UNITED STATES TAX COURT

T.C. Memo. 2002-294

UNITED STATES TAX COURT

THOMAS K. AND BILLE J. SCALLEN, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2563-00.

Filed November 27, 2002.

Saul A. Bernick and Neal J. Shapiro, for petitioners.

David L. Zoss, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

RUWE, Judge:

Respondent determined deficiencies of $735,745

and $38,296 in petitioner Thomas K. Scallen’s Federal income

taxes for 1989 and 1990, respectively.

Respondent determined

deficiencies of $25,933, $75,798, and $65,669, in petitioners

Thomas K. Scallen’s and Bille J. Scallen’s Federal income taxes

- 2 for 1992, 1994, and 1995, respectively.1

The parties filed a

joint motion to sever the issue relating to Bille J. Scallen’s

joint and several liability, which we granted.

After

concessions,2 the only issue for decision is whether certain

debts formerly owing to petitioner were business bad debts for

purposes of section 166(a).3

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.

At the time of filing the

petition, petitioners resided in Minneapolis, Minnesota.

1

Petitioner Bille J. Scallen is a party to this case by

reason of the fact she filed joint Federal income tax returns

with Thomas K. Scallen for tax years 1992, 1994, and 1995.

References to petitioner are to Thomas K. Scallen.

2

Petitioners concede that a certain Magazine Publishing

Company, Inc., debt is an S-corporation item and not a trade or

business bad debt; petitioners concede that a certain Stephen

Scallen debt is a nonbusiness bad debt; petitioners concede

certain Schedule E income adjustments of $8,638 and $42,151 for

1994 and 1995, respectively; and the parties agree that if the

Court sustains respondent’s determinations, then the correct

amount of petitioner’s allowable itemized deduction for interest

expense is $226,203 instead of $245,043 as determined in the

notice of deficiency. Respondent concedes the issue relating to

his determination of unreported investment interest income of

$25,000, $262,000, and $2,000 in 1990, 1991, and 1992,

respectively.

3

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the tax years at issue.

All Rule references are to the Tax Court Rules of Practice and

Procedure.

- 3 Petitioner is an experienced businessman, a producer, a

radio personality, and a lawyer.

Petitioner received a bachelor

of arts degree (1949) and a law degree (1950) from Denver

University.

He worked 5 years as an assistant attorney general

for the State of Minnesota, acting as a trial lawyer for the

Minnesota Highway Department.

He also worked for 1 year in the

mid-1950s as counsel to the judiciary committee of the Minnesota

State Senate.

From 1956 to 1964, petitioner practiced law full

time, and he thereafter practiced law part time.

After 1964,

petitioner spent approximately 95 percent of his time working on

his own business deals and as an employee of various companies.

In 1964, petitioner became president of the Bank of

Minneapolis, a downtown retail bank in Minneapolis.

This bank

was a small bank, and each of its officers, including petitioner,

was a loan officer.

Petitioner acted as a loan officer for about

4 or 5 years, and as a loan officer he evaluated

creditworthiness, the character of the borrower, the cashflow of

the business, the market value of the borrower’s collateral, and

“things like that”.

Petitioner was also president of the Lake

City State Bank in Lake City, Minnesota.

International Broadcasting Corporation (IBC)

Petitioner incorporated International Broadcasting

Corporation (IBC) in April 1981.

IBC was a publicly held

company, and its stock was traded on the NASDAQ national stock

- 4 exchange.

IBC’s corporate office was located at 5101 IDS Tower,

which was also petitioner’s office address.

Petitioner was a shareholder, director, and the chief

executive officer of IBC from April 1981 to August 1996; he was

its president from 1982 to 1995.

Petitioner spent at least 80

percent of his time operating IBC.

Petitioner received wages

from IBC and/or its subsidiaries for each of the years 1987 to

1995.4

Petitioner’s personal financial statements report the

following number of IBC shares owned by petitioner and their

value:

Date

Number of shares

Value

11/30/86

08/31/88

10/31/89

10/31/90

09/30/91

01/31/92

03/31/93

02/28/94

6,605,000

472,200

472,200

472,200

472,200

472,200

472,200

472,200

$1,321,000

4,958,100

5,961,525

2,361,000

472,200

118,050

47,250

47,200

In the mid-1980s, IBC decided to go into the entertainment

business, and, in 1984, it bought the CBS television affiliate,

KTAB TV, in Abilene, Texas.

IBC paid $9 million for KTAB TV,

which was financed with a loan from Marine Midland Bank of New

York. The bank required petitioner to guarantee this loan.

Petitioner was to receive 1 percent or $90,000 as a guaranty fee

4

Petitioner received wages of $471,805, $488,496, $419,712,

$495,226, $460,385, $539,149, and $8,351, in 1987, 1988, 1989,

1990, 1991, 1992, and 1993, respectively.

- 5 from IBC for his guaranty.

IBC sold KTAB TV 2 years later for

about $16 million.

On December 17, 1986, petitioner executed a guaranty

agreement in favor of certain banks with respect to loans of $15

million to IBC.

The banks were represented by National

Westminster Bank USA (Natwest), as agent.

The loans were made in

connection with IBC’s acquisitions of the Harlem Globetrotters

and the Ice Capades, Inc.5

The guaranty agreement states that

“It is in the best interests of the undersigned [i.e.,

petitioner] that the Borrower, which is directly owned in part by

the undersigned, be able to obtain the loans provided for in the

Loan Agreement”.

The minutes of the special meeting of the board

of directors of IBC, held on February 13, 1987, describe the

circumstances of the guaranty by petitioner and authorize payment

of a guaranty fee:

The Board then held a lengthy and detailed

discussion of compensation for Thomas K. Scallen,

President of the Corporation. The Board noted Mr.

Scallen had personally guaranteed the Corporation’s

$15,000,000 obligation to National Westminster Bank,

USA (“Natwest”) incurred in the acquisition of The

Harlem Globetrotters and Ice Capades and recognized

that the duties and responsibilities had greatly

increased as a direct result of these acquisitions.

The importance of Mr. Scallen to the success of the

Corporation has been indicated by the request for “key

man insurance” by Natwest. The directors determined

5

Petitioner coproduced and directed the Ice Capades. He

traveled with the show and was actually on the ice floor with the

performers during production. Petitioner’s son, Thomas M.

Scallen, operated the Harlem Globetrotters.

- 6 that his activity and direction are absolutely

essential to the success of this Corporation. Upon

motion duly made and seconded, Thomas K. Scallen

recused himself, the following preambles and

resolutions were adopted:

WHEREAS:

It is highly advantageous to this Corporation to

assure the continued employment of Thomas K.

Scallen as its President because of his vast

business experience and expertise in corporate

governance.

WHEREAS:

The President has not been compensated for his

personal guaranty of the obligation to Natwest

which guaranty now continues until the guaranteed

obligation is satisfied, and these actions were

not within the scope of his employment agreement

with the Company.

NOW, THEREFORE,

BE IT RESOLVED:

That any other director of the Corporation is

hereby authorized and directed on behalf of this

Corporation to execute an amendment to the

Schedule of Compensation attached to the Executive

Employment Agreement between the Corporation and

Thomas K. Scallen, dated July 11, 1983, increasing

the annual salary of Thomas K. Scallen to

$250,000, effective as at January 1, 1987.

FURTHER

RESOLVED:

That, in consideration of the extension of his

personal guaranty as aforesaid, the reasonable

value of which, in the opinion of the Board of

Directors, other than Thomas K. Scallen, is at

least equal to the amount of $150,000, Thomas K.

Scallen is hereby entitled to receive as and for

compensation for the extension of such guaranty

the sum of $150,000.

- 7 FURTHER

RESOLVED:

That any Vice President of this Company is hereby

authorized and directed to execute and deliver to

Thomas K. Scallen a check in the amount of

$150,000 in full consideration of the extension of

said guaranty upon obtaining the consent of

Natwest to such payment.

At some point in or about 1988, Natwest made loans to IBC in

the aggregate principal amount of $25 million.

On June 1, 1988,

petitioner guaranteed up to $17.5 million of those loans.

The

guaranty states that “It is in the best interests of the

undersigned [i.e., petitioner] that the Borrower, which is

directly owned in part by the undersigned, be able to obtain the

loans provided for in the Loan Agreement”.

The board of

directors for IBC determined that $175,000 was “a reasonable fee”

for petitioner’s guaranty and authorized the payment of that

amount to petitioner.

On May 25, 1989, IBC Amusement Rides, Inc.,6 executed a term

note of $1.5 million in favor of Fantasy Rides, Inc., pursuant to

a purchase agreement by and among a number of parties including

IBC and Charles R. Wood, one of IBC’s directors.7

On May 26,

1989, petitioner and IBC executed a guaranty in favor of Fantasy

6

IBC Amusement Rides, Inc., was a wholly owned subsidiary of

IBC.

7

The purchase agreement and note related to the acquisition

of Charles R. Wood’s interests in Great Escape and Fantasy

Island.

- 8 Rides, Inc., with respect to the term note.

Mr. Wood required

petitioner’s guaranty as a condition precedent to his acceptance

of the note from IBC Amusement Rides, Inc.

Petitioner

reluctantly agreed to this guaranty in order to close the

purchase agreement and in recognition that the acquisition

transaction was in jeopardy without his guaranty.

A resolution

by IBC’s board of directors describes the circumstances of the

guaranty and authorizes a guaranty fee be paid to petitioner:

In May 1989, at the time the acquisition of Mr. Wood’s

interests in Great Escape and Fantasy Island were in

the final stage of negotiation, NatWest requested that

Mr. Wood’s three-year promissory note be subordinated

in all respects to the obligation of the Company to

NatWest. Mr. Wood, when advised of this request,

declined to complete the transaction unless he received

adequate security for the $1,500,000 obligation of the

Company and that adequate security, in his opinion, was

the personal guarantee of Thomas K. Scallen, who was

reluctant to provide the guarantee. However, in

recognition that the transaction was in jeopardy,

Thomas K. Scallen agreed to provide the guarantee.

The Directors discussed possible alternative financing

to the guarantee or payment to Mr. Wood in order to

determine the appropriateness of fees. Mr. Denis A

Mola discussed the approach of an investment banker,

including comparisons to “bridge loans” which would

normally require 5 points over the life of the loan

taking into consideration periodicity. Mr. Mola

further advised that to obtain such a “bridge loan”

would have required the Company give a substantial

equity call on the Company. The Directors discussed

the lack of security or the subordination, and the

availability of potential alternatives for Mr. Thomas

K. Scallen’s personal guarantee; the timing of the

granting of the guarantee; the reluctance of Mr. Wood

to go forward with the transaction unless the guarantee

was provided; the comparison to the “bridge loans” and

the requirement to give up equity to provide it. After

further discussion, Mr. Lawrence Beasley moved and Mr.

- 9 George K. Hagglund seconded (Mr. Charles R. Wood and

Mr. Thomas K. Scallen abstaining), the following

resolutions were adopted:

NOW, THEREFORE,

BE IT RESOLVED:

That, in consideration of the extension of his

personal guaranty of the obligation of the Company

to Charles Wood, the reasonable value of which, in

the opinion of the Board of Directors, other than

Thomas K. Scallen and Charles Wood, is at least

equal to the amount of $150,000. The compensation

for the extension of such guaranty in the amount

of $150,000 is hereby ratified and confirmed.

In 1990, petitioner guaranteed a loan of $8.5 million from

Natwest to IBC.

The board of directors for IBC authorized a

guaranty fee of 1 percent ($85,000) be paid to petitioner.

On February 23, 1990, petitioner executed a guaranty in

favor of Natwest with respect to a $60 million loan made by

Natwest and other banks to IBC.

The guaranty states that “The

Guarantor [i.e., petitioner] is a shareholder of the Borrower and

will derive benefits, both directly and indirectly, by virtue of

the loans being made to the Borrower”.

IBC paid to petitioner loan guaranty fees of $150,000,

$175,000, $150,000, and $85,000, in 1987, 1988, 1989, and 1990,

respectively, for the various guaranties discussed above.

- 10 Western Media Group Corp. (WMG)

Western Media Group Corp. (WMG), formerly known as Ionic

Controls, Inc.,8 was incorporated in 1980.

WMG was a publicly

held company, and its stock was traded in the over-the-counter

market.

WMG owned a library of recordings, it was involved in

oil and gas activities, and it operated an iron and steel

company.

WMG’s principal corporate office and records were also

located at 5101 IDS Center.

Petitioner was a shareholder, officer, and director of WMG.

Petitioner acquired an interest in WMG in 1981, and at all times

relevant, he held 2.5 percent of its issued and outstanding

shares.

Petitioner’s personal financial statements report the

following number of shares petitioner owned and their value:

Date

Number of shares

Value

11/30/86

08/31/88

10/31/89

10/31/90

09/30/91

01/31/92

03/31/93

02/28/94

05/31/95

124,000

124,000

124,000

124,000

124,000

124,000

124,000

124,000

124,000

$12,400

12,400

23,250

23,250

23,250

12,400

23,250

23,250

23,250

Petitioner did not receive wages or other compensation for

services from WMG during 1987-95.

In 1987, WMG’s oil and gas assets were nearly exhausted, and

its iron and steel company commenced a bankruptcy proceeding.

8

In

At the annual meeting of its shareholders on Nov. 17, 1988,

Ionic Controls, Inc., changed its name to Western Media Group

Corp. (WMG).

- 11 1989, WMG was contemplating a public offering to facilitate its

entry into new areas of business; i.e., it was considering

publishing and broadcasting (radio and television) activities.

WMG decided to acquire an AM radio station, KXDC-AM, in Monterey,

California, and an FM radio station, KXDC-FM, in Carmel,

California, for an aggregate cost of $2.65 million.

The

acquisition of KXDC was proposed to petitioner by William

Retzlaff, who informed petitioner that WMG required a “bridge

loan” in order to purchase KXDC.

Petitioner and WMG expected

that any loans made by petitioner would be repaid from the

proceeds of a public offering.

Petitioner made a “very extensive

examination” of KXDC; he had a consulting engineer; and he met

with a reputable sales manager who agreed to work as general

manager of KXDC.

He also met with certain media people,

advertisers, and radio station operators in the Monterey area to

confirm the value of the property and the marketplace.

He

determined that the value of KXDC was $2.7 million.

To facilitate WMG’s acquisition of KXDC, petitioner entered

into a loan agreement with Natwest on April 19, 1989.

The

agreement called for a loan or loans of up to $3 million due on

the earlier of April 30, 1990, or the sale of 4.5 million units

of WMG in a public offering.

Petitioner entered into a

contemporaneous agreement with WMG in which he agreed to lend WMG

up to the aggregate principal sum of $3 million.

This loan

- 12 agreement extended over the same time period as the agreement

with Natwest.

In connection with the loan agreement, WMG

executed a note in favor of petitioner.

The loan agreement between petitioner and Natwest and the

loan agreement between petitioner and WMG provided for the same

interest rates.9

The loan agreement with Natwest provided that

petitioner would pay Natwest a “commitment fee” as defined in the

agreement10 and a facility fee of 1 percent.

The agreement with

WMG, meanwhile, provided that WMG would pay petitioner a

nonrefundable commitment fee of 10 percent ($300,000).

WMG’s

obligation to petitioner was the subject of a security agreement,

which petitioner perfected by filing a financing statement with

the Secretary of State’s office for the State of California.

The

security agreement provided petitioner a security interest in all

the assets of WMG, including its corporate office, AM and FM

transmitters, studios, and call letters.

In accordance with his

loan agreement with Natwest, petitioner executed an assignment

9

WMG’s note provided that the interest rate on the loan from

petitioner to WMG was “equal to the rate set forth in the Loan

Agreement payable by Scallen to National Westminster Bank USA”.

10

The loan agreement provided for a commitment fee on a

quarterly basis in arrears equal to one-half of 1 percent per

annum of the daily average amount of the unused loan commitment

from Apr. 19, 1989, until the Natwest commitment was terminated

or the “Commitment Termination Date”, as defined in the

agreement.

- 13 document and then assigned the WMG note and other collateral to

Natwest.

In 1989, petitioner borrowed $2.65 million and $350,000,

separately, under the Natwest loan agreement, which amounts he in

turn lent to WMG pursuant to his loan agreement with that

company.

Petitioner advanced additional funds to WMG in 1989,

which petitioner represents totaled $696,456.21.

Petitioner made

additional advances to WMG of $643,646.85, $236,450, $29,610.49

in 1990, 1991, and 1992, respectively.

In 1990 and 1991, Century

Park Pictures Corp. (CPPC)11 made loans to WMG.

In 1991,

petitioner made payments of $223,164.44 to CPPC on the notes

issued by WMG, and he treated those payments as additional

advances to WMG.

WMG made payments of $124,050, $25,000, $262,000, and $2,000

to petitioner in 1989, 1990, 1991, and 1992, respectively.

Those

amounts were applied to reduce the principal balance then owing

from WMG to petitioner.

WMG accrued interest expense on its note

to petitioner in 1989 and 1990.

Petitioner reported the receipt

of $900 interest income from WMG on Schedule B, Interest and

Ordinary Dividends, of his 1989 Federal income tax return.

Petitioner did not report any interest income from WMG in 1990,

1991, or 1992.

11

IBC held a minority interest in Century Park Pictures

Corp. (CPPC). Petitioner also owned stock in CPPC.

- 14 Following the purchase of KXDC, the business started going

downhill.

The sales people whom Mr. Retzlaff brought to the

station were trading station time for personal items, and the

station manager fell in love with a Greek fisherman and moved to

Greece without telling WMG.

Further, Mr. Retzlaff had

represented that there was an underwriter who was going to sell

WMG’s stock in the public offering; however, this representation

was false.

WMG incurred a loss from continuing operations of

$933,378 in 1989, and it had a negative net worth of $951,552.

WMG incurred an additional loss of $1,054,792 in 1990.

In or

about this time, petitioner repaid the $3 million loan from

Natwest with proceeds from the sale of another business in which

he had an interest.

In early 1990, petitioner determined that WMG would not be

able to repay the loan proceeds received from petitioner and that

it was necessary to sell WMG’s radio stations to realize their

remaining value.

In March 1990, petitioner and WMG agreed to

rescind WMG’s obligation to petitioner for the 10-percent

commitment fee.

The letter from petitioner to the board of

directors of WMG rescinding the commitment fee agreement states:

This confirms my offer and your acceptance to rescind,

effective October 13, 1989, the agreement to pay a

commitment fee of $300,000 to me in consideration of my

obtaining a bridge loan and operating loan to Western

Media Group Corporation at the time of acquisition of

KXDC-AM & FM. I no longer am obligated to National

Westminster Bank, USA (the “Bank”) as change of

circumstance subrogates me to the Bank’s position.

- 15 Accordingly, I will be receiving interest at the

contract rate during the term of the loan and the

purpose for the commitment fee has been mitigated.

In addition, I agreed to extend the term of the loan to

July 31, 1990 or upon the successful completion of the

current public offering, whichever is first.

On January 21, 1991, an unrelated party later incorporated

as the Joaquin Financial Group, Inc. (Joaquin), made an offer to

purchase the KXDC-AM and KXDC-FM radio stations from WMG for $1.1

million.

On July 31, 1991, WMG and Joaquin closed on the

purchase.

Joaquin paid WMG $239,514 cash for part of the

purchase price and issued a promissory note of $860,486 for the

remainder.

WMG assigned the Joaquin note to petitioner in 1991.

Petitioner applied the Joaquin note to reduce the principal

balance which WMG owed him.

Joaquin defaulted on its obligation,

and on November 6, 1992, petitioner sent a notice of default to

Joaquin.

In 1995, petitioner received a final receivership

distribution of $549,764.18 with respect to Joaquin’s note.

In addition to the promissory note executed by WMG for up to

$3 million, WMG executed other promissory notes in favor of

petitioner:

Date

Amount

04/21/89

04/28/89

05/23/89

06/09/89

06/19/89

07/07/89

07/11/90

07/19/90

08/15/90

$200,000

20,000

20,000

35,000

75,000

45,000

27,000

73,000

20,000

Interest rate

12%

12

13.5

13

13

13

11

11

11

Due

Demand

Demand

Demand

Demand

Demand

Demand

Demand

Demand

Demand

- 16 Not all petitioner’s loans and advances to WMG were the subject

of promissory notes.

Medical Investment Corporation (Medicor)

In the early 1960s, petitioner formed a company called

Medical Investment Corp. (Medicor), which was in the business of

leasing medical equipment to doctors.

Petitioner was the chief

executive officer of this company.

Medicor bought the Olmstead County Bank located in

Rochester, Minnesota.

The purchase of the bank was financed with

a loan from the First National Bank of St. Paul.

Petitioner

endorsed the note issued to First National Bank, which made him

liable as a principal.

Petitioner began as the senior vice

president of the Olmstead County Bank, and he later became the

acting executive officer and chief loan officer.

In the early 1970s, Medicor changed its corporate purpose,

and it acquired the Shipstead and Johnson’s Ice Follies.

It also

owned Northwest Sports Entertainment (Northwest) which, in turn,

owned the Western Hockey League franchise of the Vancouver

Canucks.12

In December 1970, Northwest purchased a $3 million

certificate of deposit from the Bank of the South Pacific and

Trust Co., Ltd. (South Pacific), a wholly owned Bahamian company

12

In an annual report to the Securities and Exchange

Commission, Medicor reported owning 60.1 percent of the voting

securities of Northwest.

- 17 of Medicor.

South Pacific then lent $3 million to Medicor.

Medicor also received $500,000 in intercompany advances from a

subsidiary of Northwest.

On June 17, 1971, Capozzi Enterprises,

Ltd., lent $3,648,575 to Medicor so that Medicor could redeem the

certificate of deposit and repay the intercompany advances and

related expenses.

In an annual report submitted to the

Securities and Exchange Commission, Medicor reported:

The Registrant [Medicor], by Agreement dated December

17, 1971, borrowed $4,000,000 Canadian funds from the

Bank of British Columbia, Vancouver, British Columbia,

and concurrently therewith repaid a loan made June 17,

1971 by Capozzi Enterprises, Ltd., Vancouver, British

Columbia, to the Registrant in the amount of $3,127,849

U.S. funds and $532,648 Canadian funds. The proceeds

of that loan (June 17, 1971) were used to repay certain

indebtedness of the Registrant’s wholly-owned

subsidiary, the Bank of the South Pacific and Trust

Co., Ltd., to Northwest Sports Enterprises, Ltd., * * *

in the amount of approximately $3,000,000 and the

repayment of additional indebtedness of the Registrant

to Northwest in the amount of approximately $500,000.

These debts were both guaranteed by the Registrant and

its President, T. K. Scallen. * * * [Emphasis added.]

The record does not show whether petitioner guaranteed the

Capozzi loan or whether he received any fees for the guaranties

that he made with respect to the above transactions.

In 1971, petitioner lent $310,000 to Medicor.

He received

as collateral all the outstanding stock of South Pacific, which

had a value of approximately $300,000 and a subordinated position

in other investments of $77,500.

- 18 Accounting and Tax Return Preparation

Petitioner borrowed funds to finance the loans that he made

to WMG and other companies in which he held an interest.

Those

funds were borrowed from various credit card companies with whom

petitioner had lines of credit.13

After depositing the proceeds

from those borrowings, petitioner used his personal checking

account to advance funds to WMG and other entities.

Petitioner

made monthly payments, generally the minimum amount due, to the

credit card companies.

The monthly payments covered interest.

Kelly Posthumus was an accountant employed by IBC.

She

maintained petitioner’s personal checking account records, wrote

checks to pay his bills, prepared schedules of his loans to

companies, and prepared yearend schedules and summaries for

petitioner’s tax accountants.

Every time petitioner made a loan

to a company, Ms. Posthumus recorded it on a schedule set aside

for that particular company.

Each loan was separated by date,

check number, and amount on the schedule.

At the end of each

year, Ms. Posthumus would review petitioner’s credit card and

credit line statements and prepare a schedule of petitioner’s

interest expense for the year to give to petitioner’s tax

accountants.

The yearend schedules and summaries were also

prepared from check registers of petitioner’s checking accounts.

13

The credit card accounts from which petitioner obtained

funds to make loans to WMG had high interest rates, perhaps as

high as 20 percent.

- 19 Ms. Posthumus did not keep track of the interest rates applicable

to the loans that petitioner made, and she was not personally

aware whether anyone for petitioner sent periodic statements to

the debtor companies that he lent money.

Petitioner did not keep

or maintain records reflecting the accrued interest that WMG owed

him.

Petitioner hired McGladrey and Pullen, L.L.P., to do his

personal and business accounting and to prepare his tax returns

beginning in the 1980s through 1992.

Petitioner’s tax returns

were prepared from the schedules prepared by Ms. Posthumus.

McGladrey and Pullen also did accounting work for WMG, and it

prepared amortization schedules and maintained records for the

accrued interest WMG owed petitioner.

An employee of McGladrey and Pullen, James Estes, a C.P.A.,

assisted petitioner in his tax return preparation and planning.

Petitioner met with Mr. Estes in December 1990 to discuss his

income and deductions for 1990.

Among the items discussed were

petitioner’s loans to WMG which he at that time did not

anticipate as being collectible, and the impact the loans would

have on his taxes.

meeting states:

A memorandum prepared by Mr. Estes from that

“It is desired to claim a loss with respect to

the uncollectible notes in 1990.

In addition it is desired to

claim the loss as an ordinary loss.”

- 20 Petitioner’s Federal income tax returns for 1987, 1988, and

1989, included a Schedule C, Profit or (Loss) From Business or

Profession, for each year relating to “T Scallen Presents”

described as an “entertainment” activity.14

On line 21 of

petitioner’s Form 1040, U.S. Individual Income Tax Return, for

1987, and on line 22 of his Forms 1040 for 1988 and 1989, he

reported the loan guaranty fees that he received from IBC in

those years as “other income”.15

Petitioner’s income tax returns

for years subsequent to 1989 did not include Schedules C for the

“T Scallen Presents” entertainment activity.

Instead, the

returns for 1990-1995 contained a Schedule C for an unnamed

business activity described as “lending/financing”.16

On his

returns for those years, petitioner did not claim deductions for

any expenses relating to his receipt of loan guaranty fees from

IBC or any other party.

The returns for 1990-94 each included a

14

Petitioner’s tax returns for 1987-92 listed his occupation

as “executive”.

15

Mr. Estes, who prepared petitioner’s tax returns for those

years, testified that the decision to report the guaranty fee

income on lines 21 or 22 “would have been made by either myself

or one of the persons involved in the preparation of the return”.

Mr. Estes testified that this was done as a matter of convenience

and that it had no affect on the calculation of petitioner’s tax

liability whether the items were reported on Schedules C or lines

21 or 22.

16

Petitioner reported the guaranty fee that he received in

1990 from IBC on Schedule C, Profit or (Loss) From Business or

Profession, of his Form 1040, U.S. Individual Income Tax Return,

for that year.

- 21 disclosure statement that stated petitioner was engaged in a

trade or business which consisted of:

(1) The extension of loan

guaranties in exchange for fees; and (2) making loans in

anticipation of a high rate of return in the form of interest

income in respect of those loans.

On the returns for 1990-93, petitioner claimed the following

bad debt deductions, relating to his loans to WMG, on his

Schedules C for those respective tax years:

Tax Year

1990

1991

1992

1993

WMG

$2,741,053

437,614

887,610

9,112

In the notices of deficiency issued to petitioner(s), respondent

determined that petitioner’s lending and financing activities for

1990-95 did not constitute a trade or business.

Respondent

determined that the bad debt amounts should have been reported as

nonbusiness bad debts on Schedule D, Capital Gains and Losses, of

petitioner’s returns for those years.17

17

Petitioner filed Forms 1045, Application for Tentative

Refund, in which he sought to carry back net operating losses

from 1990, 1991, and 1992, to 1989. Each of those claimed

carrybacks was disallowed by respondent in the notice of

deficiency for 1989. Petitioners filed a Form 1040X, Amended

U.S. Individual Income Tax Return, for 1992 in which they claimed

an additional net operating loss, and petitioner filed a Form

1040X for 1989 in which he claimed a net operating loss carryback

from 1992. Respondent did not allow those claims, and he did not

include them in the notices of deficiency for 1989 and 1992.

Petitioner also claims that he incurred a net Schedule C loss of

$260,388 for 1993 attributable to a lending/financing business

(continued...)

- 22 OPINION

Section 166(a) allows as a deduction any debt which becomes

worthless within the taxable year.

However, section 166(a) is

not applicable to any nonbusiness debt, and, where any

nonbusiness debt becomes worthless within the taxable year, the

loss resulting therefrom shall be considered a loss from the sale

or exchange of a capital asset held for not more than 1 year.

Sec. 166(d)(1).

A nonbusiness debt means a debt other than:

(1)

A debt created or acquired (as the case may be) in connection

with a trade or business of the taxpayer; or (2) a debt the loss

from the worthlessness of which is incurred in the taxpayer’s

trade or business.

Sec. 166(d)(2).

Business bad debts generally

include payments of principal or interest made by a taxpayer in

discharge of part or all of his obligation under a guaranty

agreement entered into in the course of a trade or business of

the taxpayer.

Sec. 1.166-9(a), Income Tax Regs.

The burden is

on the taxpayer to show his entitlement to a business bad debt

deduction.18

Rule 142(a); Litwin v. United States, 983 F.2d 997,

17

(...continued)

and a net operating loss of $249,149 for 1993 (for which he is

entitled to net operating loss carryback deductions in 1990,

1991, and/or 1992, or to net operating loss carryforward

deductions for years subsequent to 1993).

18

Petitioners do not argue the applicability of sec.

7491(a), and the record does not otherwise show whether the

examination was commenced after the effective date of that Code

section. We find sec. 7491(a) is not applicable to this case.

- 23 999 (10th Cir. 1993).

The question whether a debt is a business

or nonbusiness debt is one of fact, and it depends upon whether

the debt is proximately related to a trade or business of the

taxpayer.

Imel v. Commissioner, 61 T.C. 318, 323 (1973); sec.

1.166-5(b)(2), Income Tax Regs.

Respondent determined that petitioner was not engaged in the

trade or business of lending or financing as he claimed on his

Federal income tax returns for 1990-95.

Petitioner contends, on

the other hand, that he has a long history of making loans and

guaranties that together shows that he was involved in the trade

or business of making loans and guaranties.

To be engaged in a trade or business, 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.

Commissioner v. Groetzinger, 480 U.S. 23,

35 (1987); see also Golanty v. Commissioner, 72 T.C. 411, 425-426

(1979), affd. without published opinion 647 F.2d 170 (9th Cir.

1981).

Section 166(a) is applicable only to the exceptional

situations in which the taxpayer’s activities in making loans

have been regarded as so extensive and continuous as to elevate

that activity to the status of a separate business.

Commissioner, supra at 323.

Imel v.

In determining whether the taxpayer

is in the trade or business of lending money, we consider:

(1)

The total number of loans made; (2) the time period over which

- 24 the loans were made; (3) the adequacy and nature of the

taxpayer’s records; (4) whether the loan activities were kept

separate and apart from the taxpayer’s other activities; (5)

whether the taxpayer sought out the lending business; and (6) the

amount of time and effort expended in the lending activity and

the relationship between the taxpayer and his debtors.

United

States v. Henderson, 375 F.2d 36, 41 (5th Cir. 1967); Serot v.

Commissioner, T.C. Memo. 1994-532, affd. without published

opinion 74 F.3d 1227 (3d Cir. 1995).

Petitioner argues that he was in the trade or business of

“making loans and guaranties”; he relies on the following summary

of guaranties and loans that petitioner claims he made:

Guaranties petitioner made

Year

Debtor

1984

1987

1988

1989

IBC

IBC

IBC

IBC Amusement

Rides, Inc.

IBC

1990

Total

Amount of guaranties

Guaranty fee

$9,000,000

15,000,000

17,500,000

$90,000

150,000

175,000

1,500,000

8,500,000

51,500,000

150,000

85,000

650,000

Loans petitioner made

1

Year

Debtor

Amount of loans

Number of loans

1979-86

1989

1989

1990

1991

1992

Total

IBC

WMG

WMG

WMG

WMG

WMG

$397,738

3,000,000

1

696,456

643,646

236,450

2

10,560

3

4,989,850

125

1

23

61

25

5

240

Respondent points out that this amount includes $90,843.21, which petitioner

paid to Natwest in 1989, in respect of his personal obligation to Natwest.

- 25 2

Petitioner also claims to have paid six items of WMG expense, totaling

$19,050.49, in 1992.

3

The total of the loans listed above is actually $4,984,850.

Respondent contends that petitioner’s return treatment for the

lending and financing activity in 1990-95 is inconsistent with

his return treatment for that activity during prior tax years;

therefore, evidence of the prior tax years is “irrelevant”, and

we should only consider those loans and guaranties which occurred

in 1990-95.19

We disagree.

Petitioner’s loans and guaranties during prior tax years are

relevant in determining whether he was in the trade or business

of making loans and guaranties.

We do not agree with respondent

that petitioner’s failure to list lending or financing as his

trade or business on returns for tax years prior to 1990, or his

failure to report guaranty fees on a Schedule C, forecloses

petitioner’s reliance on loans and guaranties that he made during

those prior years.

Indeed:

Reporting an activity on Schedule C is indicative

of a trade or business. However, petitioner’s failure

to so report his income from lending activities on

Schedule C is not conclusive of the absence of a trade

or business. This is particularly true when as here

the return was prepared by a CPA. [Ruppel v.

Commissioner, T.C. Memo. 1987-248.]

19

Respondent argues that petitioner’s failure to report the

IBC guaranty fees received in 1987, 1988, and 1989, as Schedule C

income from a lending and financing trade or business, was

“factually inconsistent with the mandate of I.R.C. § 6011(a).”

- 26 Nevertheless, we should point out that our holding in this

respect should not be read to suggest that petitioner’s failure

to report a trade or business on Schedule C for the prior years

is irrelevant.

In that regard, a taxpayer’s listing of his

occupation as an “executive” on his tax returns and his failure

to file a Schedule C in connection with a purported trade or

business are factors that indicate that the taxpayer is not in

the trade or business of lending money.

Commissioner, T.C. Memo. 1983-526.

Estate of Bounds v.

Thus, although petitioner’s

failure to report a trade or business on Schedule C in the prior

years is not conclusive, we weigh this factor with other factors

in determining whether petitioner was in the trade or business of

making loans and guaranties.20

After considering the loans and

guaranties for the prior years and for the years at issue, we

cannot conclude that petitioner was engaged in any such trade or

business.

20

Respondent also alleges that petitioner’s activities prior

to 1990 are irrelevant in that they “have no apparent factual

nexus with his activities in the years at issue and are not

probative” whether he was engaged in a trade or business in 1990.

We cannot agree. Each of the activities in this case involved

loans and guaranties made to, or made with respect to, a company

in which petitioner held an interest. Moreover, we cannot agree

that a “factual nexus” is required amongst the individual

transactions that together establish a trade or business.

Indeed, as petitioner points out: “The more extensive the loans,

more numerous borrowers and longer time interval when loans are

made, the stronger the argument for a trade or business.”

- 27 Petitioner did not advertise for customers in the course of

his lending and financing activities.

There is no evidence of

record that he held a reputation in the community as a lender or

as a guarantor.

As part of his lending and financing activities,

petitioner lent money only to companies in which he held an

interest.

He guaranteed loans only with respect to those same

companies.

Petitioner points to no loans or guaranties involving

unrelated parties or parties with whom he had no direct

involvement as an investor.21

Petitioner did not actively pursue

loan or guaranty opportunities with respect to either the general

public or within his community of companies.

Petitioner made

loans or guaranties when the need arose with respect to one of

his companies.

Petitioner devoted most of his time to IBC and

his other activities.

He has not shown that he devoted any

significant time to WMG, and he was not paid for any of his

services thereto.

The record does show a long history (from the

1960s to the 1990s) of loans and guaranties petitioner made to

companies in which he held an interest.

However, that history is

broken and sporadic, and it certainly is by no means continuous.

See United States v. Henderson, 375 F.2d at 41.

21

Lending activities confined to corporations in which the

taxpayer has an interest, generally, do not give rise to a trade

or business of making loans. Putoma Corp. v. Commissioner, 66

T.C. 652, 674 n.33 (1976), affd. 601 F.2d 734 (5th Cir. 1979).

- 28 Petitioner had no employees for the activity other than

those employed in the IDS Tower office.

He included the wages or

compensation for those employees as part of his general office

overhead.

None of those expenses were reflected on his personal

tax returns or on the Schedules C.

Petitioner did not engage, on

any consistent basis, in the type of formal activities that one

might associate with a lending and financing trade or business.

It would have been impossible to perceive his lending and

financing activities as a trade or business separate from his

personal or his companies’ affairs.

Moreover, the testimony of Ms. Posthumus and the testimony

of petitioner indicate that petitioner maintained none of the

records that would show the profits actually earned or which

might be expected to be earned on loans from petitioner to his

companies.

To that extent, respondent describes petitioner’s

records as “anemic”, and he contends that petitioner “had no

means of determining whether he was re-loaning borrowed funds at

positive, or profitable, interest rate spreads or at negative, or

unprofitable, interest rate spreads.”

Given the record before

us, we agree with respondent.

Petitioner contends that the most important test in

determining whether he is engaged in the trade or business of

making loans and guaranties is “the extent of the activity”;

i.e., the number of loans and guaranties and the respective

- 29 amounts.

Petitioner claims that “Other Courts have determined

that taxpayers were in the trade or business with a volume less

than shown by Thomas Scallen”, citing Cushman v. United States,

148 F. Supp. 880 (D. Ariz. 1956) (loans totaling $88,352 over 2

years); Serot v. Commissioner, T.C. Memo. 1994-532 ($1,950,000 in

loans over a 9-year period); Ruppel v. Commissioner, T.C. Memo.

1987-248 ($1,379,000 in loans over 4 years); Minkoff v.

Commissioner, T.C. Memo. 1956-269 ($300,000 in loans over 5

years).

However, petitioner has overemphasized the role that the

number of loans and, for that matter, the number of guaranties

play in determining whether there exists a trade or business.

We

agree that the volume of activity, e.g., lending and making

guaranties, is indicative of a trade or business; however, that

factor alone does not establish a trade or business.

Petitioner borrowed funds from credit card companies at high

interest rates and then lent those same funds to his companies.

There is no evidence that petitioner used any of his personal

funds to make these various loans, and there is no evidence that

petitioner was able to obtain, or expected to obtain, any

differential between the interest on loans from the credit card

companies to petitioner and the interest on loans from petitioner

to companies in which he had an interest.22

22

We cannot conclude

For example, in Ruppel v. Commissioner, T.C. Memo. 1987248, a case petitioner relies upon, the taxpayer borrowed money

(continued...)

- 30 that petitioner engaged in these lending transactions to earn a

profit from the interest on the loans.

We cannot conclude that

the numerous loans over the course of years were part of any

trade or business of petitioner.

With respect to IBC, petitioner claims that he made 125

separate loans or advances totaling $397,738 to IBC between 19791986.

Petitioner testified that those loans were made whenever

IBC was “short of money, and they needed help” and that he got

interest on these loans.

Petitioner relies on a handwritten

schedule entitled “Loans from T.K. Scallen to IBC:

checks

written to IBC by TKS”, which lists the dates of the purported

loans, their amounts, and the check numbers for the loans.

The

record otherwise does not show the circumstances of the loans to

IBC, and we have no reasonable basis for concluding whether those

loans represented bona fide indebtedness, from where petitioner

obtained the funds advanced to IBC, and whether petitioner

expected to earn a profit from the interest on those loans.

With respect to the many advances made to WMG in 1989-92,

petitioner claims that those advances should be considered loans

made as part of his claimed lending and financing business.

22

(...continued)

to fund his lending activities at a lower interest rate than his

customers, and “he could earn a profit from the interest rate he

charged in excess of what he paid.” Moreover, in that case, the

taxpayer maintained amortization schedules containing interest

rates, and the number of payments was printed and distributed to

the borrowers. None of those facts are apparent herein.

- 31 However, the circumstances under which those advances were made

show otherwise.

Soon after WMG purchased the AM and FM radio stations, those

activities went downhill.

After petitioner realized that WMG was

unlikely to be capable of repaying the $3 million he lent it in

1989, he continued to advance funds to WMG to keep the company

going and to protect the value of his collateral.

Petitioner

testified:

Q

Now, when in 1990 did you determine that WMG was

not going to be able to repay you?

A

I’m not sure of the date. It was just a

continuing deteriorating situation.

Q

And as I understand your testimony, the funds that

you continued to advance to Western Media after that

point were to try and preserve what value was there in

the radio station?

*

*

*

*

*

*

*

A

* * * What I was trying to say, and perhaps

didn’t say it very well, is that if the station goes

dark and off the air, it has no value. The value is

the license and the format and the continuing

broadcast. And that’s what I was trying to preserve.

Q

I understand that. But at that point, the

advances you made after you determined that the loan

wasn’t going to be repaid was to protect what value

there was there. It was not to make interest income?

A

Absolutely.

Given petitioner’s testimony and the circumstances which gave

rise to the advances, we cannot agree that those advances were

made for the opportunity of earning high returns on interest

- 32 income as petitioner claimed in the disclosure statements

attached to his returns for 1990-94.

Petitioner could not have

reasonably expected repayment on those advances, and any

expectation of a profit would have been imaginary, especially

considering the high rates of interest which attached to

petitioner’s borrowing of the funds advanced.

The advances were

made for the sole purpose of protecting petitioner’s original

loan of $3 million.

That loan and the commitment fee do not

establish a trade or business of making loans and guaranties.

The loan from Natwest to petitioner and the loan from

petitioner to WMG had the same interest rates.

Petitioner could

not have earned, or expected to earn, a profit on that series of

loans.

As petitioner suggests, he was acting as a mere conduit

between Natwest and WMG, because WMG was to cover all the

principal, interest, and fees that petitioner might incur with

respect to Natwest.

Thus, in substance, the series of loans

resembles a typical guaranty arrangement, and the commitment fee

that petitioner was to receive from WMG resembles a typical

guaranty fee.

The only possible business reason we find on the

record for petitioner in making this loan commitment was the

opportunity of receiving the commitment fee.

However, similar to

petitioner’s other guaranty arrangements, it appears this fee was

a mere afterthought.

Further, the rescission of the commitment

fee that petitioner offered and which WMG accepted suggests that

- 33 this fee may have been intended only as additional security.23

We cannot agree that provision for this fee alone establishes a

trade or business.

In addition, the guaranties made with respect to IBC do not

establish a trade or business for petitioner.

Several, if not

all, of the guaranties were made in connection with IBC’s or a

subsidiary’s acquisition of another business or company.

Petitioner made those guaranties as a means of accomplishing the

acquisition and only after he was approached by the company and

informed that the deal might not go through.

The receipt of a

guaranty fee appears to be just an afterthought with respect to

those guaranties.

For example, petitioner testified with respect

to the 1984 guaranty of the IBC loan:

Q

And why did you do the loan guarantee?

A

Because it was necessary to expedite the

transaction, and I felt that it was a good business

proposition. I thought the value was -- in the

collateral was excellent. And I charged a fee for

doing it.

Also, with respect to IBC Amusement Rides, Inc.’s acquisition of

the Ice Capades and the Harlem Globetrotters, petitioner

testified as to why he signed a guaranty:

way of expediting the transaction.

23

“Well, again, it was a

It was done through a bank I

Respondent contends that the rescission of the WMG

commitment fee shows it was “intended as additional security

rather than as an intended source of profit for petitioner.”

- 34 was familiar with.

It looked like a good business opportunity to

me, because I was well secured.

And I was able to make a fee.”

The minutes of the board of directors of IBC and the

resolutions that relate to the authorization of guaranty fees to

petitioner also show a lack of business initiative, and indeed

reluctance, on the part of petitioner to make the guaranties.

If

anything, those minutes, the resolutions, and petitioner’s

testimony indicate to us that petitioner made the guaranties to

protect or enhance his investment interest in IBC and not as a

part of a lending or financing trade or business.

Further, it is not altogether clear that there was any

agreement or understanding regarding guaranty fees in place

before or contemporaneous with petitioner’s making of the various

guaranties.

Respondent suggests that the lack of assurance of

receiving fees from IBC is inconsistent with petitioner’s claim

of a trade or business of making guaranties.

Respondent argues

that the fees were not approved until the passing of the formal

resolutions, that petitioner guaranteed debts before “his

entitlement to the related guarantee fee became an approved

fact”, and that his guaranties “can only be construed as

gratuitous acts which he intended to protect and/or benefit his

then existing interests in IBC”.

Petitioner testified that the

board’s resolutions authorizing the fees were made after he had

guaranteed the various loans; however, he also testified that the

- 35 written authorization simply memorialized what the board had

previously agreed to as part of informal discussions.

Petitioner

testified that “I certainly felt entitled to rely on that.

are honorable men on that board of directors.

These

I had no

concerns.”

The minutes and resolutions, which relate to the various

guaranty fees from IBC, show that there was much more going on

than the informal discussions that petitioner alludes.

Although

it is clear that petitioner expected some fee from IBC at the

time of making the guaranties, it is not clear that he was aware

of the amount, if any, that he would receive.

Only upon formal

authorization by the board do we find any assurance of a guaranty

fee being paid to petitioner.

Certainly, the lack of formalism

in petitioner’s making the guaranties and obtaining assurance

other than reliance on the “honorable men” of the board is a

factor inconsistent with the existence of a trade or business.

Petitioner also relies upon the guaranties made during the

1960s and 1970s with respect to loans involving Medicor.

However, the record does not show that petitioner received any

fees with respect to those guaranties, and guaranties alone

without the related fees would be insufficient to support a

finding of a trade or business.

Petitioner claims to have

received a 1-percent fee on the endorsement of the note for the

- 36 1963 Medicor acquisition of the Olmstead County Bank.

He relies

solely on his own testimony, which we find less than compelling:

Q

Do you recall what fee that was, or the amount of

that fee?

A

I believe -- and I’m not sure. This was a long

time ago. But I think it was 1 percent of the amount

of the loan.

Petitioner also claims that he received a 1 and 3/4-percent fee

on what he purports to be South Pacific’s loan of $3 million to

Northwest on June 17, 1971.

To support his position, petitioner

cites his attorney’s opening statement and an annual report

submitted to the Securities and Exchange Commission.

Neither of

those items supports petitioner’s position.

Petitioner suggests for the first time on brief that, with

respect to WMG, “If, as the Commissioner suggests, the taxpayer

was trying to preserve his income as an officer of the

corporation, then he is entitled to take the deductions as

ordinary losses.”

It is well established that a taxpayer’s

status as an employee is a business interest.

See United States

v. Generes, 405 U.S. 93, 101 (1972); Halle v. Commissioner, T.C.

Memo. 1983-760.

However, it is a fact that petitioner did not

receive wages or other compensation for services from WMG during

the period 1987 to 1995.

Thus, it is not plausible that

petitioner made the loan to WMG with the dominant motivation of

protecting any business interest as an employee in WMG, and there

- 37 is no evidence that petitioner was to receive or expected to

receive any compensation as a result of the loan.

Petitioner has not shown he was engaged in the trade or

business of making loans and guaranties at any relevant time in

the instant case.

Petitioner is not entitled to business bad

debt deductions for the amounts he lent to WMG.

An appropriate order

will be issued.