UNITED STATES TAX COURT

T.C. Memo. 1998-423

UNITED STATES TAX COURT

CERAND & COMPANY, INC., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2767-97.

Filed November 24, 1998.

Gerard A. Cerand (an officer), for petitioner.

Gregory S. Matson and Warren P. Simonsen, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge:

Respondent determined deficiencies in

petitioner’s Federal income tax for tax years 1990, 1991, and

1992 in the amounts of $6,994, $10,709, and $143,406,

respectively.

The issue for our consideration is whether bad

debt deductions taken in 1990 and 1991 are allowable under

- 2 section 166.1

The remainder of respondent’s determination, the

1992 net operating loss (NOL) carryforward and a charitable gift

deduction, is purely computational adjustments caused by the

reduction of petitioner’s ordinary loss deduction and the

corresponding increase in income.

Respondent contends that the extension of credit to

corporations wholly owned by petitioner’s sole shareholder

constituted equity investments in those companies.

As such,

respondent argues that the corporations’ subsequent failures

resulted in capital rather than ordinary losses for petitioner.

Petitioner counters that the lines of credit were valid debt

incurred by the corporations, and the corporations’ inability to

repay the debt created an ordinary loss for petitioner under

section 166.

FINDINGS OF FACT

The stipulation of facts and the exhibits attached thereto

are incorporated herein by this reference.

Petitioner Cerand & Company, Inc., offers consulting

services concerning the operation of airport parking lots.

Petitioner was located in Washington, D.C., at the time the

petition in this case was filed.

1

Petitioner’s president is

Unless otherwise stated, all section references are to

the Internal Revenue Code in effect for the taxable years in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

- 3 Gerard A. Cerand, who held 95 percent of the stock until 1989

when he became petitioner’s sole shareholder.

Because petitioner’s consulting business involved extensive

travel to airports with varying accessibility throughout the

United States, Mr. Cerand needed certain air taxi/charter

services.

In 1984, responding to this need, he formed three new

corporations, First World Corp. (FWC), Cerand Aviation (CAI), and

Airport Service Corp. (ASC), based in Culpeper County, Virginia.

These separate corporations had a business purpose:

to allow

petitioner greater growth while limiting any potential

catastrophic liability to petitioner in the event of an aviation

accident.

Mr. Cerand was the president and owner of the three

new corporations, although no stock was ever issued.

The three new companies and petitioner were intertwined.

FWC provided administrative services to CAI and ASC, such as

labor, employee health benefits, and insurance.

CAI provided the

air taxi/charter service to petitioner and other outside

clientele, as well as providing aviation instruction to outside

clientele.

ASC provided the aviation support services.

Petitioner provided working capital to these companies

through an “open account receivable”, or line of credit, on which

the three corporations consistently drew advances.

Petitioner

paid a total of $1,413,374.17 to FWC, CAI, and ASC from 1984

until 1991.

No formal loan agreements or notes were drawn up,

- 4 nor was any repayment schedule set.

From time to time, the three

corporations made cash repayments, or book entry credit was made

to the advances for services rendered to petitioner.

While the

corporations were viable, they repaid $414,220 to petitioner.

Petitioner accrued interest only sporadically on the advances to

two of the corporations and failed to accrue any interest against

the advances to the third, contrary to the advice of Mr. Cerand’s

tax adviser.

The interest that petitioner did accrue on its

books was rolled over annually into a note receivable and

reported as income by petitioner.

Because that income was never

actually received by petitioner, respondent has allowed a

deduction against ordinary income for that amount.

The three corporations used funds received from petitioner

to pay operating expenses.

the corporations.

No capital assets were purchased by

Instead, all assets were leased, primarily

from Mr. Cerand.

In 1989, the corporations experienced two costly and

devastating events, the loss of FWC’s lease for ASC’s operations

at Culpeper County Airport and the loss of CAI’s Government

contract comprising approximately 90 percent of its business.

These events caused the demise of CAI and ASC in 1990, with FWC

close behind in 1991.

Once the companies went out of business, there were no

assets to seize as repayment, except for a key man life insurance

- 5 policy on Mr. Cerand held by FWC with $160,859 cash surrender

value.

Petitioner recovered the cash surrender value and

reported the income as a debt reduction.

No further attempts

were made to secure payment from the three defunct corporations.

In 1990, petitioner claimed a bad debt deduction for the

unpaid balances of ASC and CAI.

In 1991, petitioner claimed a

bad debt deduction for FWC’s unpaid balance.

In 1992, petitioner

claimed an NOL carryforward that was generated by the bad debt

claims.

Respondent disallowed the following bad debt deductions

as ordinary losses, determining that they were capital losses.

Cerand Aviation, Inc.

Aviation Services Corp.

First World Co., Inc.

Total

1990

$174,760

43,331

--218,091

1991

----$681,112

681,112

Respondent asserts that the funds advanced by petitioner were

actually capital contributions to equity rather than debt.

If

the bad debt deductions are not allowed as ordinary losses, then

the 1992 NOL carryforward is not allowable, and a previously

unavailable charitable deduction would be allowed.

OPINION

The sole adjustment under consideration involves the

question of whether petitioner is entitled, under section 166, to

business bad debt deductions for 1990 and 1991 due to the failure

of FWC, CAI, and ASC to repay advances made by petitioner.

All

other adjustments depend on the outcome of this primary issue.

- 6 Section 166 provides for deductions against ordinary income

for business bad debts that become worthless during the year.

To

be entitled to the deduction, the taxpayer must prove a bona fide

debtor-creditor relationship obligating the debtor to pay the

creditor-taxpayer a fixed or determinable sum of money.

Indus., Inc. v. Commissioner, 95 T.C. 257 (1990).

to capital are not considered debt.

Calumet

Contributions

Kean v. Commissioner, 91

T.C. 575, 594 (1988); sec. 1.166-1(c), Income Tax Regs.

The

classification of a payment as debt or equity for Federal tax

purposes is a question of fact.

Segel v. Commissioner, 89 T.C.

816, 827 (1987).

The fact that the debtor and creditor are related parties

does not preclude the existence of a bona fide debt.

Indus., Inc. v. Commissioner, supra at 286.

Calumet

However, the form of

the transaction and the labels parties place on the transaction

may not have as much significance when the corporation is closely

held because the parties are free to mold the transaction.

Fin

Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir.

1968).

For this reason, petitioner’s characterization of the

fund transfer as an open account receivable is not determinative.

In resolving similar questions of debt versus equity,

various appellate courts have identified and considered similar

factors.

See, e.g., Estate of Mixon v. United States, 464 F.2d

394, 402 (5th Cir. 1972) (13 factors); A.R. Lantz Co. v. United

- 7 States, 424 F.2d 1330 (9th Cir. 1970) (11 factors); Fin Hay

Realty Co. v. United States, supra (16 factors); Georgia-Pacific

Corp. v. Commissioner, 63 T.C. 790 (1975) (13 factors).

factors considered include:

The

(1) The names given to the

certificates evidencing the indebtedness; (2) presence or absence

of a fixed maturity date; (3) source of payments; (4) right to

enforce payments; (5) participation in management as a result of

the advances; (6) status of the advances in relation to regular

corporate creditors; (7) intent of the parties; (8) identity of

interest between creditor and stockholder; (9) “thinness” of

capital structure in relation to debt; (10) ability of

corporation to obtain credit from outside sources; (11) use to

which advances were put; (12) failure of debtor to repay; and

(13) risk involved in making advances.

Dixie Dairies Corp. v.

Commissioner, 74 T.C. 476, 493-494 (1980).

The identified factors are not equally significant.

of Mixon v. United States, supra at 402.

Estate

Nor is any one factor

determinative or relevant in each case due to the countless

factual circumstances possible.

326 U.S. 521, 530 (1946).

John Kelley Co. v. Commissioner,

“The various factors * * * are only

aids in answering the ultimate question whether the investment,

analyzed in terms of its economic reality, constitutes risk

capital entirely subject to the fortunes of the corporate venture

or represents a strict debtor-creditor relationship.”

Fin Hay

- 8 Realty Co. v. United States, supra at 697.

The ultimate question

is whether there was a genuine intention to create a debt, with a

reasonable expectation of repayment, and if that intention

comported with the economic reality of creating a debtor-creditor

relationship.

Litton Bus. Sys., Inc. v. Commissioner, 61 T.C.

367, 377 (1973).

Applying the relevant factors to the present facts, it

becomes evident that petitioner did not intend to establish a

debtor-creditor relationship with FWC, CAI, and ASC.

Instead,

the contributions made by petitioner were in actuality equity

investments in the common owner’s companies.

First, we look at the particulars of the transaction,

including the name given to the certificates of debt and the

presence or absence of a maturity date or a repayment schedule to

indicate debt or equity.

Petitioner never used any certificate

or instrument to memorialize the debt; no loan agreements or

notes were ever signed.

Nor did petitioner set a fixed maturity

date or a repayment schedule for the three companies.

The

absence of a maturity date on a note weighs against finding that

the transfers were loans.

Stinnett’s Pontiac Serv. Inc. v.

Commissioner, 730 F.2d 634, 638 (11th Cir. 1984), affg. T.C.

Memo. 1982-314.

Moreover, petitioner failed even to show that a

predetermined interest rate applied or that the interest accrued

on the advances was at market rate.

See Rule 142(a) (petitioner

- 9 has the burden of proof unless otherwise provided by statute or

the Court).

Second, the payments themselves may denote the nature of

debt or equity.

The source, the consistency, and the enforcement

of repayment are factors to consider.

The repayment to

petitioner was inconsistent and appeared dependent on financial

success.

Accordingly, the source of the repayment was more like

equity rather than debt.

Moreover, while petitioner insists that

there was a right to enforce payments from the three companies,

petitioner never made any efforts to do so beyond recovering the

cash surrender value of FWC’s life insurance policy on Mr.

Cerand.

The third group of factors are those factors traditionally

considered by lenders, such as capitalization, risk, the

availability of financing from outside sources and the use to

which advances are put.

“[T]he touchstone of economic reality is

whether an outside lender would have made the payments in the

same form and on the same terms.”

at 828.

Segel v. Commissioner, supra

The three new companies were thinly capitalized, with no

capital assets, and more than $1.4 million was advanced over time

to meet operating expenses.

With thin capitalization and no

historical success, there was considerable risk in advancing the

funds.

That risk became reality when the three companies failed

to repay over two-thirds of the money they received from

- 10 petitioner before going out of business.

Though no outside

financing was sought, it is reasonable to assume that an outside

financier would not have accepted similar credit terms:

an open,

unsecured line of credit with no set interest rate, no set

payment schedule, and no fixed maturity date to three companies

with no financial history and no capital assets.

As shown by their actions, the parties intended the funds

advanced to be an investment in FWC, CAI, and ASC.

For these

reasons, we find that petitioner made an equity investment in

FWC, CAI, and ASC.

When the three failed to repay petitioner the

funds it had extended, petitioner suffered a capital loss.

In light of the foregoing,

Decision will be entered under

Rule 155.