UNITED STATES TAX COURT
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T.C. Memo. 2002-172
UNITED STATES TAX COURT
DONALD G. OREN AND BEVERLY J. OREN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2681-00.
Filed July 19, 2002.
Myron L. Frans, for petitioners.
John C. Schmittdiel, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge:
Respondent determined the following
deficiencies with respect to petitioners’ Federal income taxes:
Year
Amount
1993
1994
1995
$1,375,232
2,138,632
1,777,271
- 2 The issues for decision are:
(1) Whether petitioners had
sufficient basis in indebtedness under section 1366(d)1 from
which to deduct losses from two wholly owned S corporations; and
(2) whether petitioners were at risk under section 465 for
certain loans made to the two S corporations.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference.
Petitioners Donald G.
Oren (Mr. Oren) and Beverly J. Oren (Mrs. Oren) resided in
Roseville, Minnesota, at the time they filed their petition.
Petitioners owned stock in several S corporations.
Those
corporations performed various functions which together formed
the nexus for petitioners’ trucking business.
Dart Transit Company (Dart) was formed in 1934 by Mr. Oren’s
father and was incorporated in 1938 under Minnesota law.
In
1993, 1994, and 1995, Dart held a 48-State authority and operated
throughout the United States and in some provinces in Canada.
During that time period, Dart was in the process of expanding and
positioned itself in the “high service just-in-time” segment of
the truckload carrier industry.
Dart offered premium truckload
carrier services to retailers and manufacturers of products such
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue.
- 3 as haul containers, paper, department store merchandise, building
materials, appliances, plastics and rubber products, and
miscellaneous items.
Dart owned no tractors of its own and used
tractors operated only by independent contractors.
The following table details some of Dart’s business
operations for 1993, 1994, and 1995:
Year
Revenues
Net Income
Item
Ordinary
Income
1993
1994
1995
$130,034,000
149,039,000
168,172,000
$2,858,133
4,539,008
3,067,744
$5,294,491
10,089,762
4,667,063
Employees
Trailers
220
241
245
1,669
1,669
2,066
Mr. Oren did not become involved in the operations of Dart
until 1953.
However, Mr. Oren would become the principal force
behind Dart’s and, another company, Fleetline’s position in the
truckload carrier business.
Mrs. Oren was also involved in the
trucking business, for more than 20 years, and was in charge of
Dart’s human resources.
Mr. and Mrs. Oren were the only
directors of Dart in 1993, 1994, and 1995.
Mr. Oren also served
as president/ treasurer, and Mrs. Oren served as executive vice
president/ secretary.
Dart had two classes of common stock, class A voting stock
(33,000 shares) and class B nonvoting stock (3,267,000 shares).
Both classes had equal distribution and liquidation rights.
Oren owned all the class A voting stock.
Overall, the common
Mr.
stock of Dart, including both the class A voting and class B
- 4 nonvoting stock, was owned by the following parties and in the
following percentages:
Common Stock Ownership Percentage
1993
1994
1995
Owners
Donald G. Oren
Beverly J. Oren
David Oren
Daniel Oren
Bradley Oren
Angela Oren
Trust for David Oren
Trust for Daniel Oren
Trust for Bradley Oren
Trust for Angela Oren
74.94%
6.33
0.26
0.26
0.26
0.26
4.43
4.43
4.43
4.43
54.95%
6.33
5.25
5.25
5.25
5.25
4.43
4.43
4.43
4.43
54.95%
6.33
5.25
5.25
5.25
5.25
4.43
4.43
4.43
4.43
David, Daniel, Bradley, and Angela Oren are petitioners’
children.
In 1992, David was age 34; Daniel was 32; Bradley was
27; and Angela was 14.
The trusts owning stock in Dart were all
qualified subchapter S trusts under section 1361(d)(1)(B).
The
trusts were irrevocable, and all rights incident to the ownership
of the stock were exercised by trustees.
None of the trustees
were employed by or held shares in any of the trucking companies;
the trustees were in all respects independent.
Dart elected to
be taxed under subchapter S of the Code for taxable years 1993,
1994, and 1995.2
See sec. 1362(a).
Mr. Oren testified that he and his wife attended seminars on
estate planning and made estate planning one of their top
business priorities.
2
As a result, Mr. and Mrs. Oren engaged in a
Dart was formerly a C corporation and still had accumulated
earnings and profits in 1993, 1994, and 1995, attributable to its
C corporation existence.
- 5 program of annual gifting of Dart shares to their children and to
irrevocable trusts for the benefit of the children.
Petitioners
reported taxable gifts in excess of $5.5 million for taxable
years 1992, 1993, and 1994 and paid approximately $2 million in
gift taxes.
In 1982, Mr. Oren established a second truckload carrier
company in Texas called Fleetline, Inc. (Fleetline).
This
company performed services similar to those of Dart.
Fleetline’s
stock was owned entirely by Mr. Oren.
Highway Leasing (HL) was incorporated in 1987 as a Minnesota
corporation.
All the stock of HL was owned by Mr. Oren.
Mr.
Oren served as the president/treasurer of HL, and Mrs. Oren
served as secretary.
Mr. Oren was the only director of HL.
was in the business of acquiring and leasing trailers.
the trailers to Dart, Fleetline, and other parties.
HL
HL leased
The
following table details some of the business operations of HL for
1993, 1994, and 1995:
Item
Year
Revenues
Net Income
Ordinary
Income
1993
1994
1995
$6,295,000
8,587,000
10,919,000
$965,237
635,746
2,447,233
$(2,845,625)
(4,459,488)
(6,825,523)
Trailers
2,068
2,550
3,847
HL elected to be taxed as an S corporation for taxable years
1993, 1994, and 1995.
Highway Sales (HS) was incorporated in 1971 as a Minnesota
corporation.
All the stock of HS was owned by Mr. Oren.
Mr.
- 6 Oren also acted as the treasurer of the company, and Mrs. Oren
acted as vice president/secretary during 1993, 1994, and 1995.
Mr. Oren and Mrs. Oren were the only directors of HS.
HS
purchased tractors which HS then leased under a “lease-topurchase” program.
HS leased the tractors to individuals who
wanted to become owner-operators of the tractors.
The
profitability of HS was dependent on its ability to purchase a
number of tractors at wholesale prices and to lease those same
tractors to individuals willing to own their own trucks and drive
them.
The following table details some of the business
operations of HS for 1993, 1994, and 1995:
Year
Revenues
Net Income
Item
Ordinary
Income
1993
1994
1995
$8,361,000
11,202,000
13,798,000
$1,634,071
322,689
1,451,609
$(1,511,830)
(1,773,473)
482,405
Employees
Tractors
11
19
19
852
1,231
1,184
HS also elected to be taxed as an S corporation for taxable years
1993, 1994, and 1995.
The various entities, Dart, Fleetline, HL, and HS, were kept
separate from one another in order to:
(1) Minimize exposure to
liability by keeping as many assets as possible out of the
primary truckload carriers, Dart and Fleetline; (2) promote
accountability within each segment of the trucking business; (3)
maintain flexibility of operations; (4) permit financial results
to be reported separately; and (5) facilitate family and estate
planning.
- 7 On July 1, 1991, Dart, Fleetline, HS, and HL entered into a
credit agreement with First Bank National Association (First
Bank), which provided for a letter of credit, a revolving note,
and a security agreement.
The credit agreement restricted
distributions from the Dart companies to petitioners’ expected
tax liability plus 10 percent of net income.
On August 16, 1993,
the agreement was amended to allow distributions to petitioners
so long as they made equivalent cash contributions to one of the
other Dart companies.
The agreement also stated:
Section 6.10 Investments. No Borrower [any of the
Dart Companies] will acquire for value, make, have or
hold any Investments, except:
*
*
*
*
*
*
*
6.10(f) Loans by Dart to Donald G. Oren, but only
so long as contemporaneous loans of equal amount from
Donald G. Oren to another Borrower remain outstanding.
Beginning in 1992, HL purchased additional trailers for use
in its business.
The trailers would have given rise to
depreciation deductions that would have exceeded Mr. Oren’s basis
in his S stock.
Mr. Oren would have been unable to deduct the
full amount of the losses as a result of section 1366(d), which
limits losses to the sum of a shareholder’s basis in the S
corporation stock and the shareholder’s basis in indebtedness of
the S corporation to the shareholder.
Mr. Oren was advised by
his tax advisers to “restructure” his financial investments in
- 8 his various companies so that he might receive the benefit of the
ordinary loss deductions.
Mr. Oren followed the advice of the
tax advisers and entered into a series of lending transactions
for the purpose of increasing basis in HL.3
On December 22, 1993, Dart lent $4 million to Mr. Oren.
Mr.
Oren executed a note which provided that principal was due 375
days following demand.
Interest accrued at a 7-percent annual
rate and was due on December 22, 1994, and on the same day of
each year thereafter.
The proceeds of the loan were distributed
in the form of a check (#133680) from Dart to Mr. Oren drawn on
Dart’s account with First Bank Havre (Havre).4
On December 22, 1993, Mr. Oren lent $4 million to HL.
HL
executed a note which provided that principal was due 375 days
following demand.
Interest accrued at a 7-percent annual rate
and was due on December 22, 1994, and on the same day of each
year thereafter.
The proceeds of the loan were distributed in
the form of a check (#2720) from Mr. Oren to HL drawn on Mr.
Oren’s account with Fidelity Investments (Fidelity).
3
Even though Mr. Oren ultimately chose to use funds lent by
Dart to finance his investments in HL, Mr. Oren testified that he
had the personal resources to finance the investments without
borrowing from Dart.
4
Mr. Oren testified that Dart had a zero balance account
(ZBA). With respect to a ZBA, each time that Dart wrote a check,
it would be drawing on its line of credit with the bank.
- 9 On December 22, 1993, HL lent $4 million to Dart.
Dart
executed a note which provided that principal was due 375 days
following demand.
Interest accrued at a 7-percent annual rate
and was due on December 22, 1994, and on the same day of each
year thereafter.
The proceeds of the loan were distributed in
the form of a check (#2305) from HL to Dart drawn on HL’s account
with First Bank Minneapolis (Minneapolis).
On September 22, 1994, Dart lent $5 million to Mr. Oren.
Mr. Oren executed a note which provided that principal was due
375 days following demand.
Interest accrued at a 7-percent
annual rate and was due on September 22, 1995, and on the same
day of each year thereafter.
The proceeds of the loan were
distributed in the form of a wire transfer from First Bank
National Association to Mr. Oren’s Fidelity account.
On September 22, 1994, Mr. Oren lent $5 million to HL.
HL
executed a note which provided that principal was due 375 days
following demand.
Interest accrued at a 7-percent annual rate
and was due on September 22, 1995, and on the same day of each
year thereafter.
The proceeds of the loan were distributed in
the form of a check (#2875) from Mr. Oren to HL drawn on Mr.
Oren’s Fidelity account.
On September 22, 1994, HL lent $5 million to Dart.
Dart
executed a note which provided that principal was due 375 days
- 10 following demand.
Interest accrued at a 7-percent annual rate
and was due on September 22, 1995, and on the same day of each
year thereafter.
The proceeds of the loan were distributed in
the form of a check (#2402) from HL to Dart drawn on HL’s account
with Havre.
On September 15, 1995, Dart lent $4.4 million to Mr. Oren.
Mr. Oren executed a note which provided that principal was due
375 days following demand.
Interest accrued at a 7-percent
annual rate and was due on September 15, 1996, and on the same
day of each year thereafter.
The proceeds of the loan were
distributed in the form of a check (#164603) from Dart to Mr.
Oren drawn on Dart’s account with Havre.
On September 27, 1995, Mr. Oren lent $4.5 million to HL.
executed a note which provided that principal was due 375 days
HL
following demand.
Interest accrued at a 7-percent annual rate
and was due on September 27, 1996, and on the same day of each
year thereafter.
The proceeds of the loan were distributed in
the form of a check (#3066) from Mr. Oren to HL drawn on Mr.
Oren’s Fidelity account.
On September 27, 1995, HL lent $4.5 million to Dart.
Dart
executed a note which provided that principal was due 375 days
following demand.
Interest accrued at a 7-percent annual rate
and was due on September 27, 1996, and on the same day of each
- 11 year thereafter.
The proceeds of the loan were distributed in
the form of a check (#2512) from HL to Dart drawn on HL’s account
with Havre.
In 1995, a similar problem arose with HS.
HS purchased
tractors and the accelerated depreciation deductions from those
tractors were anticipated to exceed Mr. Oren’s basis in HS.
Mr.
Oren restructured his investments to increase his basis in HS.
On December 8, 1995, Dart lent $1.9 million to Mr. Oren.
Mr. Oren executed a note which provided that principal was due
375 days following demand.
Interest accrued at a 7-percent
annual rate and was due on December 8, 1996, and on the same day
of each year thereafter.
The proceeds of the loan were
distributed in the form of a check (#168445) from Dart to Mr.
Oren drawn on Dart’s account with Havre.
On December 21, 1995, Mr. Oren lent $2 million to HS.
HS
executed a note which provided that principal was due 375 days
following demand.
Interest accrued at a 7-percent annual rate
and was due on December 21, 1996, and on the same day of each
year thereafter.
The proceeds of the loan were distributed in
the form of a check (#3088) from Mr. Oren to HS drawn on Mr.
Oren’s Fidelity account.
On December 21, 1995, HS lent $2 million to Dart.
Dart
executed a note which provided that principal was due 375 days
- 12 following demand.
Interest accrued at a 7-percent annual rate
and was due on December 21, 1996, and on the same day of each
year thereafter.
The proceeds of the loan were distributed in
the form of a check (#16973) from HS to Dart drawn on HS’ account
with Minneapolis.
Mr. Oren signed all the above notes either in his individual
capacity or as president of Dart or HL.
The only exception was
the note from HS to Mr. Oren which was signed by John Seibel,
president of HS.
Mr. Oren’s financial statements for 1993 and 1995 do not
reflect Mr. Oren’s loan obligations to Dart or the loan
obligations from HL and HS to Mr. Oren.
The 1993 and 1994
combined balance sheets for the Dart companies do not reflect the
loan obligations between Dart and Mr. Oren, Mr. Oren and HL, and
HL and Dart.5
The 1995 combined balance sheet for the Dart
5
The combined schedule of balance sheet information for 1993
provides the following relevant information (in thousands):
ASSETS
Notes receivableaffiliate
LIABILITES
Notes payableaffiliate
Dart
Fleetline
HS
HL
Eliminations
Total
$5,901
---
-–-
$4,000
($9,598)
$303
4,000
$1,598
---
4,000
(9,598)
---
The total of $303,000 was listed on the combined balance sheet of
the Dart companies as an asset. The combined schedule of balance
sheet information for 1994 provides the following relevant
information (in thousands):
Dart
Fleetline
HS
HL
Eliminations
Total
ASSETS
Notes receivable-
(continued...)
- 13 companies does not reflect the various loans between the Dart
companies and Mr. Oren, except for the $200,000 that Mr. Oren
lent to HL and HS from his own personal resources.6
That amount
is listed as a “NOTES PAYABLE-Stockholder”.7
5
(...continued)
affiliate
LIABILITES
Notes payableaffiliate
($7,307)
---
$181
$9,000
($1,598)
$276
(9,000)
1,598
---
9,000
(1,598)
---
The total of $276,000 was listed on the combined balance sheet as
an asset of the Dart companies.
6
The combined schedule of balance sheet information for 1995
provides the following relevant information (in thousands):
ASSETS
Notes receivableaffiliate
LIABILITES
Notes payablestockholder
Notes payableaffiliate
Dart
HS
HL
Total
$325
---
---
$325
(15,300)
$2,000
$13,500
200
16,037
(2,000)
(13,500)
537
The totals of $325,000, $200,000, and $537,000, are listed on the
combined balance sheet of the Dart companies under “Notes
receivable-Affiliate”, “NOTES PAYABLE-Stockholder”, and “NOTES
PAYABLE-Affiliate”, respectively. Note 7 to the combined balance
sheet then states: “The notes payable to stockholder and
affiliate are due 375 days from the date the holders of the notes
request payment. The interest rates of the notes are fixed at
7.0%.”
7
The parties stipulated an exhibit identified as Accounting
Research Bulletin No. 51, Consolidated Financial Statements,
which provides in relevant part:
In the preparation of consolidated statements,
intercompany balances and transactions should be
eliminated. This includes intercompany open account
balances, security holdings, sales and purchases,
interest, dividends, etc. As consolidated statements
(continued...)
- 14 Mr. Oren paid interest in 1994, 1995, and 1996 on the loans
made from Dart to Mr. Oren:
Date
Interest Payment
Check No. (Fidelity)
12-22-94
10-11-95
12-12-96
$280,000.00
553,288.00
1,254,246.58
3008
3073
3238
HL paid interest in 1994, 1995, and 1996 on the loans from Mr.
Oren to HL:
Date
Interest Payment
Check No. (Havre)
12-21-94
09-27-95
12-03-96
$280,000.00
553,288.00
1,121,917.81
????
2509
2641
HS also paid interest on the 1995 loan from Mr. Oren:
Date
Interest Payment
12-04-96
$132,712.33
Check No. (Minneapolis)
19438
Dart paid interest in 1994, 1995, and 1996 on the loans made from
HL to Dart:
Date
Interest Payment
Check No. (Havre)
12-23-94
09-27-95
$280,000.00
553,288.00
150561
164844
7
(...continued)
are based on the assumption that they represent the
financial position and operating results of a single
business enterprise, such statements should not include
gain or loss on transactions among the companies in the
group.
The various offsets of the loan obligations among Dart, HL, and
HS on the 1993, 1994, and 1995 combined schedule of balance sheet
information, are explained by this document. However, this
document does not explain the absence of the loans involving Mr.
Oren on the 1993 and 1994 statements.
- 15 12-04-96
1,121,917.81
186558
Dart also paid interest to HS in 1996 on the loan made from HS to
Dart:
Date
Interest Payment
Check No. (Havre)
12-04-96
$132,712.33
186559
Dart paid the following amounts to HL and HS on December 19,
1996:
Payee
Payment
Check No. (Havre)
HL
HS
$13,549,191.78
2,007,287.67
187346
187347
The notes that Dart executed for the benefit of HL were marked
“Paid 12/19/96 check # 187346”.
The note that Dart executed for
the benefit of HS was marked “Paid 12/19/96 check # 187347”.
HL paid the following amounts to Mr. Oren on December 19,
1996:
Payment
$100,364.38
13,448,827.40
Check No. (Havre)
2650
2651
The notes that HL executed for the benefit of Mr. Oren were
marked “Contribute to Capital * * * 12/18/96”.
HS paid the following amounts to Mr. Oren on December 19,
1996:
Payment
$100,364.38
1,906,923.29
Check No. (Minneapolis)
19565
19566
- 16 The note that HS executed for the benefit of Mr. Oren was marked
“Contribute to Capital * * * 12/18/96”.
On December 23, 1996, Mr. Oren satisfied his notes to Dart,
by endorsing the checks he received from HS (#19566) of
$1,906,923.29 and HL (#2651) of $13,448,827.40 to Dart’s bank
account.
The notes that Mr. Oren executed for the benefit of
Dart bear a notation reflecting this payment method.
Mr. Oren made total contributions of $19 million to HL and
HS in 1996.8
On December 23, 1996, Mr. Oren made capital
contributions of $1,198,735.36 and $1,301,264.64 to HS.
On
December 27, 1996, Mr. Oren made a capital contribution of $16.5
million to HL.
Distributions from Dart provided Mr. Oren with
the funds needed to make those contributions.
The distributions
were made pro rata to all shareholders of Dart.
Petitioners deducted losses from HL and HS on Form 1040,
U.S. Individual Income Tax Return, in the following amounts:
HL
HS
8
1993
1994
1995
($4,000,000)
(146,384)
($4,614,944)
(66,363)
($5,605,248)
(2,046,251)
On the advice of their tax advisers, petitioners filed a
Form 1040X, Amended U.S. Individual Income Tax Return, for
taxable year 1996. Attached to that return is a document which
states that the return was being filed as a protective claim.
Petitioners stated that if they should lose the Tax Court case,
they were claiming sufficient basis in 1996 from which to deduct
the losses. Petitioners based their claim on the capital
contributions made in 1996 by Mr. Oren to HL and HS.
- 17 On December 6, 1999, respondent issued a notice of deficiency for
taxable years 1993, 1994, and 1995 in which he determined:
7.A. Loss on Highway Leasing
The deductions of $4,000,000, $4,614,944, and
$5,605,248, shown on your returns for the taxable years
1993, 1994, and 1995, respectively, as losses from
Highway Leasing are not allowable for 1993 and 1994 and
is reduced by $4,785,056 for 1995 because the loans
from Dart Transit through Donald Oren to Highway
Leasing and then back to Dart Transit do not create
indebtedness and at-risk basis. Accordingly, your
taxable income is increased $4,000,000 for 1993,
$4,614,944 for 1994, and $4,785,056 for 1995.
7.B. Loss on Highway Sales
The deduction of $2,046,251 shown on your return for
1995 as a loss from Highway Sales is reduced by
$1,900,000 because the loans from Dart Transit through
Donald Oren to Highway Sales, Inc. and then back to
Dart Transit do not create indebtedness and at-risk
basis. Accordingly, your taxable income is increased
$1,900,000 for 1995.
OPINION
Issue 1
The first issue for decision is whether petitioners’ basis
in the indebtedness of two wholly owned S corporations was
increased under section 1366(d) as a result of certain direct
loans made by petitioners to those entities.
Generally, it is
the burden of the taxpayer to establish his basis in the S
corporation under section 1366(d).9
Estate of Bean v.
Commissioner, 268 F.3d 553, 557 (8th Cir. 2001), affg. T.C. Memo.
9
Petitioners do not argue that sec. 7491(a) applies, and it
is otherwise unclear when the examination by respondent
commenced. We find sec. 7491(a) is not applicable to this case.
- 18 2000-355; Parrish v. Commissioner, 168 F.3d 1098, 1102 (8th Cir.
1999), affg. T.C. Memo. 1997-474.
Section 1366(d) provides:
SEC. 1366. PASS-THRU OF ITEMS TO SHAREHOLDERS.
*
*
*
*
*
*
*
(d) Special Rules for Losses and Deductions.-(1) Cannot exceed shareholder’s basis in stock
and debt.--The aggregate amount of losses and
deductions taken into account by a shareholder under
subsection (a) for any taxable year shall not exceed
the sum of–(A) the adjusted basis of the shareholder’s
stock in the S corporation (determined with
regard to paragraph (1) of section 1367(a) for
the taxable year), and
(B) the shareholder’s adjusted basis of any
indebtedness of the S corporation to the
shareholder (determined without regard to any
adjustment under paragraph (2) of section
1367(b) for the taxable year).
The legislative history of section 1366(d) indicates that losses
are deductible only to the extent of one’s “investment” in the S
corporation, which includes cash outlays as well as loans to the
corporation from the shareholder.
The Senate Finance Committee
Report states:
The amount of the net operating loss apportioned
to any shareholder pursuant to the above rule is
limited under section 1374(c)(2) [a predecessor of
section 1366(d)] 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. * *
- 19 * [S. Rept. 1983, 85th Cong., 2d Sess. (1958), 1958-3
C.B. 922, 1141; emphasis added.]
Respondent determined that the loans Mr. Oren made to HL and
HS did not involve an economic outlay by petitioners and did not
increase basis under section 1366(d).
Respondent argues that the
transactions did not leave petitioners “poorer in any material
sense” and did not result in “any significant change” in
petitioners’ “economic wealth”.10
Petitioners suggest that the loans from Mr. Oren to HL and
HS, when viewed separately, were bona fide debts for purposes of
section 1366(d).
Petitioners contend that the “other” loan
transactions (i.e., the loans from HL to Dart and from HS to
Dart) should not upset the validity of those loans.
Petitioners
also argue that Mr. Oren’s personal economic wealth was changed
significantly as a result of the loan transactions since he was
personally indebted to Dart for repayment of the loan proceeds.
In the context of a shareholder’s guaranty of a loan for the
benefit of an S corporation, there has been some dispute as to
whether a guaranty can ever satisfy the requirements of section
1366(d)(1).
Most of the cases dealing with the issue have
determined that, as a matter of law, a mere guaranty does not
give rise to basis in indebtedness under section 1366(d)(1)(B),
10
Respondent does not challenge the bona fides of the
entities created by petitioners or the overall structure of the
trucking business adopted by petitioners.
- 20 because there has not been an “actual economic outlay” by the
shareholder to the corporation.
See, e.g., Estate of Bean v.
Commissioner, supra at 558-559; Estate of Leavitt v.
Commissioner, 90 T.C. 206, 211 (1988), affd. 875 F.2d 420 (4th
Cir. 1989).11
Petitioners argue that funds lent directly from a
shareholder to an S corporation create basis under section
1366(d), and an actual economic outlay is not required, even if
other transactions offset the direct loan.
Petitioners argue
that an actual economic outlay is required only where there is a
shareholder guaranty.
Essentially, petitioners are arguing that
the “form” of a direct loan from a shareholder to an S
corporation is sufficient to increase basis in indebtedness under
section 1366(d)(1)(B).
A shareholder must make an actual economic outlay to
increase basis in an S corporation, even if the shareholder has
made a direct loan.
Bergman v. United States, 174 F.3d 928, 932
(8th Cir. 1999); Underwood v. Commissioner, 535 F.2d 309, 311-313
(5th Cir. 1976), affg. 63 T.C. 468 (1975).
Indeed, in Bergman v.
United States, supra at 933, the Court of Appeals for the Eighth
Circuit stated:
The economic outlay doctrine does not apply only
to loan guarantees, but it has been used to explain
that a shareholder who guarantees a bank loan to an S
corporation does not create additional basis because he
11
1985).
But see Selfe v. United States, 778 F.2d 769 (11th Cir.
- 21 is only secondarily and conditionally liable. The
principle underlying the doctrine extends beyond such
circumstances to transactions which purport to be
direct loans. * * * [Citations omitted.]
Thus, “A taxpayer claiming a deduction [under section 1366(d)(1)]
must show it was based on ‘some transaction which when fully
consummated left the taxpayer poorer in a material sense.’”
Id.
at 932-933 (quoting Perry v. Commissioner, 54 T.C. 1293, 1296
(1970), affd. 27 AFTR 2d 71-1464, 71-2 USTC par. 9502 (8th Cir.
1971)).
Our concern under section 1366(d)(1)(B) is whether a
shareholder has, in substance, lent money to the S corporation.
See id., at 930 n.6.
The various disbursements in 1993, 1994, and 1995 were the
equivalent of offsetting bookkeeping entries, even though they
occurred in the form of checks and a wire transfer.
For example,
in 1993, Dart lent $4 million to Mr. Oren, Mr. Oren lent $4
million to HL, and HL lent $4 million to Dart.
transactions did not have a net economic effect.
The loan
None of the $4
million that Dart lent to Mr. Oren was retained by a party other
than Dart.12
Indeed, the loan proceeds originated with Dart and
ended with Dart.
The only significance of the transactions was
the circular route of the various checks and the wire transfer
12
For an investment, we would at a minimum expect that the S
corporation would retain the loan proceeds for use in its
business operations. In this case, the loans to HL and HS simply
entered the “front door”, immediately exited through the “back
door”, and were returned to Dart.
- 22 and the execution of promissory notes.
the parties did not change.13
The economic positions of
The same is true of the loan
transactions in 1994 and 1995.
The execution of the promissory notes did not result in the
parties’ becoming poorer in any material sense.
The promissory
notes, with the exception of the note from HS, were all executed
by Mr. Oren as president of Dart and HL, or as an individual.
The terms of the promissory notes were not the equivalent of
terms which might appear in notes executed for the benefit of
unrelated third parties, especially in light of the size of the
loans.
The loans were unsecured and were in the form of notes
due 375 days following demand.
Further, petitioners, in their
various roles as the only directors, principal officers, and
majority or sole shareholders of the Dart companies, and Mr. Oren
as individual-obligee, controlled when and whether a demand for
repayment would be made.
The loan principal repayments and the payments of interest
also denote the inherent lack of substance in the loans.
The
repayment of loans occurred only after respondent challenged the
13
Respondent suggests that petitioners’ restructuring of
investments, if upheld, permits taxpayers to create basis “out of
thin air” and “double count” basis in two S corporations and that
there would be no limit to the amount of basis that could be
created by the simple exchange of offsetting notes.
- 23 loan transactions that occurred in 1993, 1994, and 1995.14
The
repayments did not follow the procedures specified in the
promissory note; i.e., payment 375 days after demand.15
The
repayments occurred all at once and via the same circular route
as the initial disbursements.
Mr. Oren simply endorsed the
checks he received from HL and HS over to Dart.
The interest
payments, like the disbursements and repayments, were wholly
circular.
The interest payments from Mr. Oren to Dart, from HL
and HS to Mr. Oren, and from Dart to HL and HS, were in the same
amounts and were made contemporaneously.
The interest payments,
like the disbursements and repayments, were economically
14
At trial, Mr. Oren testified as follows:
Q
And what did your tax adviser recommend to you once
they found out the IRS was challenging these loans?
A
Well, they recommended that Dart pay a dividend to me
and that I use that dividend to pay off the loans to
Highway Sales and Highway Leasing, and so at that point
all the loans were repaid.
15
Petitioners suggest that the repayment method adopted
should not affect the substance of the original distribution of
funds. However, as we see it, the substance of the loan
transactions should be determined on the basis of all facts and
circumstances, including the circumstances surrounding repayment.
Petitioners also argue that the repayment of the loans was “fully
consistent with sound commercial practice.” However, Mr. Oren’s
testimony at trial and the record show that the only reasons for
the repayments were to unwind the previous transactions and to
salvage whatever tax results might be forthcoming for taxable
year 1996.
- 24 insignificant.
The parties were in exactly the same position
before the interest payments as they were afterwards.
Petitioners point to our decision in Gilday v. Commissioner,
T.C. Memo. 1982-242, and emphasize that direct shareholder loans,
like the loans in this case, create basis.
Petitioners argue
that the facts in that case are similar to those herein.
In
Gilday, the taxpayers substituted their own personal note for the
note of an S corporation that had been executed in favor of a
third-party bank.
This Court found that the taxpayers had become
primary obligors on the loan obligation to the bank and allowed
the taxpayers to increase their basis accordingly.
Id.
However, “the involvement of an independent third party
lender” was essential to the result reached in Gilday v.
Commissioner, supra.
Bergman v. United States, 174 F.3d at 933.
In this case, the “lender”, Dart, was a controlled entity.
Mr.
Oren owned all the voting stock and a majority of the nonvoting
stock, and, further, Mr. and Mrs. Oren were the only directors of
Dart and acted as its president/treasurer and executive vice
president/secretary, respectively.
Petitioners argue that a
third-party lender is not required where there is a direct loan
to an S corporation.
We agree with the rationale in Bergman v.
United States, supra, and hold that a third-party lender is
generally required.
With a third-party lender, “there is no
question that * * * [the] lender * * * intends to force
- 25 repayment, truly placing the shareholder’s money at risk.”
at 933.
Id.
But, with a controlled entity, “it may be unclear
whether the shareholder or the corporation is placed at risk.”
Id.
In such a case, the taxpayer must overcome a “a heavy
burden” and demonstrate that the loans were bona fide and had
“economic impact”.
Id.
Petitioners attempt to overcome this heavy burden and cite
several factors which suggest that Mr. Oren would be required to
make repayment to Dart in all events.
Petitioners claim that a
default on the part of Dart, HL, or HS on the various loan
obligations could have triggered a chain reaction that would have
forced Mr. Oren to pay Dart out of his own assets.
We cannot
agree.
Dart was a financially stable and expanding company.
Petitioners presented no evidence that would lead us to believe
that Dart would have been unable to repay its loan obligations to
HL and HS.
The same is true of HL and HS.
financially viable and expanding.
Both companies were
Further, given Mr. Oren’s
multicompany structure, HL’s and HS’s assets did not face the
same risks that were associated with the carrier companies, Dart
and Fleetline.
We can conclude that a default on the notes by
any of the Dart companies was highly unlikely.
In any event, it
is highly improbable that Dart would have made demand on Mr. Oren
to repay his loans from Dart.
Any demand on Mr. Oren would
- 26 surely have triggered a demand by Mr. Oren of HL and HS.
Assuming a demand by HL or HS of Dart, the entire series of
demands would simply offset, leaving the parties exactly where
they started.
Any demands for repayment would have been futile,
because each party would have had equivalent rights of demand
against other parties in the circular chain of obligations.16
The loans in this case were nothing more than a tripartite,
interconnected arrangement that, as a practical matter, would not
have given rise to an obligation on the part of Mr. Oren to repay
from his personal resources.
Petitioners also argue that the Dart minority shareholders
had rights under Minnesota law allowing them to recover on the
loans made from Dart to Mr. Oren.17
Petitioners contend that the
minority shareholders would have forced Mr. Oren to repay the
loans, even if HL or HS were unable to repay their loans to Mr.
Oren.
We disagree.
A demand for repayment on the part of the
minority shareholders of Dart would surely have triggered a
demand on HL or HS for repayment which would in turn trigger
16
Compare this result to the facts in Gilday v.
Commissioner, T.C. Memo. 1982-242. After the substitution of
notes, the taxpayers, as primary obligors, would have to repay
the loans whether the S corporation was or was not able to supply
the taxpayers with equivalent amounts. In that case, the
taxpayers might truly have to repay with personal funds.
17
Petitioners cite to Minn. Stat. Ann. sec. 302A.467 (West
1985) and Minn. Stat. Ann. sec. 302A.751 (West Supp. 2001), which
discuss equitable relief and shareholder suits.
- 27 Dart’s loan obligations to HL or HS.
In the end, the parties
would have advanced no further nor taken any steps back from
where they had started.
In any event, the minority shareholders
of Dart were petitioners’ children and trusts for the benefit of
those children.
We cannot agree that the children or the
trustees would have made demand for repayment premature to Mr.
Oren’s own wishes, especially considering other circumstances
which demonstrate that Mr. Oren had exclusive control of all
matters within the Dart companies:
Mr. Oren’s ownership of all
voting stock in the Dart companies, his orchestration of the loan
transactions in 1993, 1994, and 1995, his exclusive control over
repayment in 1996, his initiation of the First Bank credit
amendments in 1993, and the distributions that occurred in 1996
from Dart to its shareholders.
Petitioners also argue that the loan transactions had
economic substance because of “the need to finance HL and HS” and
strengthen the financial statements of the companies.
However,
the loan transactions themselves did not result in an infusion of
finances into HL and HS given that the loan proceeds were
immediately returned to Dart.
Further, petitioners have not
presented any credible evidence to substantiate the claim that
the balance sheets of the Dart companies were strengthened as a
result of the loans or that Mr. Oren adopted the form of the loan
transactions in order to accomplish such a result.
Petitioners’
- 28 assertion that the combined balance sheets were made stronger by
the loan transactions adopted, without more, is insufficient.
Indeed, at trial, Mr. Oren was unable to explain exactly how the
balance sheets were made stronger as a result of the loan
transactions.
Further, the combined balance sheets of the Dart
companies do not reflect the various loan obligations as assets
of the corporations.
In fact, the obligations simply offset one
another on the combined schedule of balance sheet information.
See supra notes 5 and 6.
We cannot see how the combined balance
sheets were strengthened, or could even be perceived as
strengthened by Mr. Oren or any financial institution.
We agree with respondent that Mr. Oren was nothing more than
a “conduit through which Dart funneled money to HL and HS and
back to itself.”18
The financial statements compiled for Mr.
Oren and for the Dart companies are consistent with this finding.
Mr. Oren’s financial statements for 1993 and 1995 do not list the
loans from Dart to Mr. Oren or the loans from Mr. Oren to HL and
HS.
The combined balance sheets of the Dart companies for 1993
and 1994 do not reflect the loan transactions.
18
The combined
In such a case, shareholders cannot claim an increase in
basis for the entity investment, even if the entity is controlled
or wholly owned. Estate of Bean v. Commissioner, 268 F.3d 553,
556-557 (8th Cir. 2001), affg. T.C. Memo. 2000-355; Bergman v.
United States, 174 F.3d 928, 932 (8th Cir. 1999) (“No basis is
created for a shareholder, however, when funds are advanced to an
S corporation by a separate entity, even one closely related to
the shareholder.”).
- 29 schedules of balance sheet information for those years do reflect
the loans; however, they show the loans as having been made from
Dart to HL and from HL to Dart.
See supra note 5.
involvement in the loans is not shown.
Mr. Oren’s
The 1993 and 1994
financial statements of the Dart companies certainly support
respondent’s position that Mr. Oren was a mere conduit among
Dart, HL, and HS.19
We hold that Mr. Oren did not make an actual economic outlay
to HL and HS.
Accordingly, the increase in Mr. Oren’s basis in
the S corporations, attributable to the loans, was limited to
$200,000, the amount lent from Mr. Oren’s personal assets.20
Issue 2
The second issue for decision is whether for purposes of
section 465 petitioners were at risk for the amounts lent to the
19
Only the 1995 financial statements note Mr. Oren’s
involvement in the various loans. On the 1995 combined balance
sheet, Mr. Oren’s $200,000 loan to HL and HS from his personal
resources is reflected; his role with respect to the loan amounts
that originated with Dart is not listed. The combined schedule
of balance sheet information for 1995 does note Mr. Oren’s
involvement with respect to those amounts: Dart is shown to hold
a “Notes payable-stockholder” of $15.3 million and HL and HS are
shown to owe “Notes payable-stockholder” of $13.5 million and $2
million. See supra note 6. Petitioners have not explained why
the methodology employed in the 1995 combined schedule differs
from that employed on the 1993 and 1994 combined schedules.
Certainly, the form of the loans in 1993, 1994, and 1995 was
identical. We are at a loss in identifying any nontax reasons
why the methodology for the 1995 schedule was so abruptly
changed.
20
In the notice of deficiency, respondent has recognized
this $200,000 increase in basis.
- 30 S corporations.
Respondent determined that the loans from Mr.
Oren to HL and HS were part of a loss-limiting arrangement under
section 465(b)(4), and, therefore, Mr. Oren was not at risk for
those amounts.21
Respondent argues that where loan transactions
are structured so as to remove “any realistic possibility” of
economic loss, taxpayers are not at risk for those amounts.
Petitioners contend that the existence of circular payments is
not per se a loss-limiting arrangement.
They argue that the
notes from Mr. Oren to Dart were fully recourse, and Mr. Oren’s
obligation to repay the loans was absolute even if HL or HS
failed to repay.
Generally, a taxpayer is at risk in an activity to the
extent of money contributed or amounts borrowed for use in the
activity.
Sec. 465(b)(1).
A taxpayer is at risk with respect to
borrowed amounts if he or she is personally liable for repayment
of the loans or, otherwise, if he or she has pledged property as
security for loan repayment.
Sec. 465(b)(2).
However, a
taxpayer is not at risk, even for amounts received in a fully
recourse loan, if he or she is protected by a loss limiting
arrangement.
Sec. 465(b)(4).
Section 465(b)(4) provides:
“Exception.--Notwithstanding any other provision of this section,
21
HL and HS were both involved in the leasing of equipment;
HL leased trailers and HS leased tractors. Respondent argues,
and petitioners do not dispute, that equipment leasing is an
activity which is subject to the at risk provisions. See sec.
465(c)(1)(C).
- 31 a taxpayer shall not be considered at risk with respect to
amounts protected against loss through nonrecourse financing,
guaranties, stop loss agreements, or other similar arrangements.”
(Emphasis added.)
Respondent claims that Mr. Oren was protected
from loss on the loans by “other similar arrangements” within the
meaning of section 465(b)(4).
In the Eighth Circuit, to which this case is appealable, in
other circuits, and in prior opinions of this Court, the “any
realistic possibility of loss” standard has been adopted for
determining whether a taxpayer is at risk under section
465(b)(4).
See Young v. Commissioner, 926 F.2d 1083, 1089 n.14
(11th Cir. 1991), affg. T.C. Memo. 1988-440;
Moser v.
Commissioner, 914 F.2d 1040, 1048 (8th Cir. 1990), affg. T.C.
Memo. 1989-142; Am. Principals Leasing Corp. v. United States,
904 F.2d 477, 483 (9th Cir. 1990); Levien v. Commissioner, 103
T.C. 120, 126 (1994), affd. 77 F.3d 497 (11th Cir. 1996);
Thornock v. Commissioner, 94 T.C. 439, 453 (1990).
Thus, where a
transaction is structured so as to remove any realistic
possibility of the taxpayer suffering a loss, the taxpayer is not
at risk for the borrowed amounts.
Levien v. Commissioner, supra
at 126.
Petitioners argue that the any realistic possibility test is
applied only in sale-leaseback cases and should not be applied in
this case which does not involve a sale-leaseback.
Petitioners
- 32 argue that the sale-leaseback cases are distinguishable from the
circular payment scenario in this case, because:
(1) The sale-
leaseback cases involved “identical and offsetting obligations of
the loan and rental payments” whereas no rental payments are
involved in this case; and (2) the sale-leaseback cases generally
involved depreciation deductions whereas, in this case, Mr. Oren
did not claim any such deductions.
However, the facts in this
case are decidedly similar to those involved in the typical saleleaseback scenario.
We cannot distinguish, for purposes of
section 465(b)(4), the circular arrangements found in Moser v.
Commissioner, supra; Am. Principals Leasing Corp. v. United
States, supra; Levien v. Commissioner, supra; etc., from the
circular arrangement found in this case.
Accordingly, we find
that the any realistic possibility standard is applicable.
Petitioners argue that, in any event, there was a realistic
possibility that the circular chain of loan and interest payments
would be broken and that Mr. Oren would be forced to repay the
loans from Dart without collecting on the loans he made to HL and
HS.
Respondent claims that petitioners are simply hypothesizing
about scenarios that might occur, none of which were likely to
occur given the peculiar set of facts in this case including the
circularity of payments, Mr. Oren’s unlimited control over the
companies, and the 375-day payment following demand provision in
the notes.
Respondent also argues that hypothetical events that
- 33 have not in fact occurred are not relevant for purposes of
section 465(b)(4).
Given the particular arrangement in this case, Mr. Oren was
insulated from actually repaying the Dart loans from his own
personal resources except if:
(1) Mr. Oren should choose to
repay the Dart loans without enforcing the notes against HL and
HS; or (2) one of the Dart companies was to become insolvent or
bankrupt, and the chain of circular payments was to be broken.
Obviously, the former is not sufficient to place Mr. Oren at
risk.
Thus, after considering all the facts and circumstances,
we must determine whether there was any realistic possibility
that the Dart companies would become insolvent or bankrupt and
the chain of circular payments would be broken.
Much of Mr. Oren’s testimony at trial was devoted to
explaining the potential risks that he was exposed to by
borrowing money from Dart and loaning money to HL and HS.
Specifically, Mr. Oren suggested that the truckload carriers were
exposed to considerable risks from potential tort claims that
might arise from automobile accidents.22
22
If Dart, HL or HS, were
At trial, Mr. Oren recounted an accident involving one of
Dart’s carriers. Dart was found liable and a jury verdict of $7
million was rendered in that case. Mr. Oren emphasized that the
verdict could have been substantially greater if it had involved
the death of more than one person. For example, Mr. Oren
recalled that the carrier narrowly missed a bus which was full of
passengers. If the carrier had hit the bus, Mr. Oren speculated
that a considerable verdict (in excess of $34 million) would not
(continued...)
- 34 to be involved in such an accident, the circle of loan payments
might be broken, and Mr. Oren might be forced to repay Dart with
his own resources.
After examining all the facts and circumstances, we cannot
conclude that there was a realistic possibility that Mr. Oren
would be required to repay the Dart loan with his own personal
resources.
There were significant cashflow and assets available
in Dart, HL, and HS from which to satisfy any potential claims of
up to $2 million without upsetting the circular offsets created
by the loan transactions.
And, claims of up to $34 million would
be covered by a general insurance policy owned by the Dart
companies.23
With respect to claims in excess of $34 million;
i.e., claims that might break the circular arrangement with the
introduction of outside creditors, petitioners have produced no
evidence of the frequency of such claims except the self-serving
and speculative testimony of Mr. Oren.
Indeed, at trial, Mr.
Oren could testify only to one accident, an accident in which a
verdict of $7 million was delivered.
approaches $34 million.
This figure in no way
We cannot agree that there was a
22
(...continued)
have been out of the question.
23
The Dart Companies owned an insurance policy which
provided general liability coverage. The policy provided that
the Dart Companies were self-insured for the first $2 million of
any claim but were covered for claims of up to $34 million. For
claims over $34 million, the Dart Companies were self-insured.
- 35 realistic possibility of a greater than $34 million claim that
would have rendered one of the Dart companies insolvent and
caused the circularity of payments to be broken.
Petitioners also suggest that a small decline in the
equipment values of HL and HS, or an economic slowdown in the
trucking business may have resulted in the elimination of
shareholder equity.
Petitioners claim that with shareholder
equity gone, HL and HS may have been unable to repay Mr. Oren.
We disagree.
Even if all the assets of HL and HS were to become
worthless, those companies would still hold the notes executed by
Dart.
To repay its loans to Mr. Oren, HL and HS could have
simply passed on the Dart notes to Mr. Oren.
Mr. Oren could then
offset his own obligations to Dart by canceling the Dart notes.
Only in a case where HL and HS were to become insolvent or
bankrupt; i.e., where outside liabilities were to exceed the
value of existing assets in those companies, might the chain of
offsetting obligations be upset.
As stated above, this was
highly unlikely.24
24
We also point out that Dart regained possession of the
funds it lent to Mr. Oren within days of the initial
disbursements. Following the return of the funds, Dart no longer
faced the risks normally associated with funds lent and retained
by third parties. The benefit of Dart’s “repossession” of the
loan proceeds not only accrued to Dart, but also to Mr. Oren
since it would be unlikely that Dart would pursue repayment of
the loan proceeds if it already possessed them.
- 36 Furthermore, we do not believe it appropriate to engage in
the type of speculation petitioners would have us make.
Indeed,
the legislative history of section 465(b)(4) indicates that
Congress intended to exclude financial difficulties from the atrisk determination:
For purposes of * * * [section 465(b)(4)], it will
be assumed that a loss-protection guarantee, repurchase
agreement or insurance policy will be fully honored and
that the amounts due thereunder will be fully paid to
the taxpayer. The possibility that the party making
the guarantee to the taxpayer, or that a partnership
which agrees to repurchase a partner’s interest at an
agreed price, will fail to carry out the agreement
(because of factors such as insolvency or other
financial difficulty) is not to be material unless and
until the time when the taxpayer becomes
unconditionally entitled to payment and, at that time,
demonstrates that he cannot recover under the
agreement. [S. Rept. 94-938, at 50 n.6 (1976), 1976-3
C.B. (Vol. 3) 49, 88.]
In the Eighth Circuit, to which this case is appealable, and in
at least one other circuit,25 examination of “the worst-case
25
See, e.g., Am. Principals Leasing Corp. v. United States,
904 F.2d 477, 483 (9th Cir. 1990):
A theoretical possibility that the taxpayer will suffer
economic loss is insufficient to avoid the applicability
of this subsection. We must be guided by economic
reality. If at some future date the unexpected occurs and
the taxpayer does suffer a loss, or a realistic
possibility develops that the taxpayer will suffer a loss,
the taxpayer will at that time become at risk and be able
to take the deductions for previous years that were
suspended under this subsection. [Citations omitted.]
See also Thornock v. Commissioner, 94 T.C. 439, 454 (1990) (“the
potential bankruptcy of entities providing guarantees or loss
protection to investors is not a consideration in determining the
(continued...)
- 37 scenario” is generally inappropriate for purposes of section
465(b)(4).
Moser v. Commissioner, 914 F.2d at 1048.26
Examining
whether a greater than $34 million lawsuit was plausible would
require us to utilize such a “doomsday” approach.
We decline
petitioners’ invitation to do so.
Accordingly, we hold that the loans that Mr. Oren made to HL
and HS did not increase petitioners’ basis in those companies for
purposes of section 1366(d)(1)(B).
Petitioners’ ability to
deduct losses for taxable years 1993, 1994, and 1995 is therefore
limited to basis amounts determined under section 1366(d) that do
not include those loans.
We also hold that petitioners were not
at risk for the amounts borrowed by Mr. Oren for use in HL and
HS.
Therefore, petitioners’ loss deductions from those companies
are limited under section 465(a) to amounts for which petitioners
are otherwise at risk.
Decision will be
entered for respondent.
25
(...continued)
application of sec. 465(b)(4) unless and until the bankruptcy
actually occurs”).
26
But see Emershaw v. Commissioner, 949 F.2d 841, 845-848
(6th Cir. 1991), affg. T.C. Memo. 1990-246.
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