UNITED STATES TAX COURT

T.C. Memo. 1999-386

UNITED STATES TAX COURT

EDWIN A. HELWIG, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 1069-98.

Filed November 29, 1999.

Martin A. Shainbaum and David B. Porter, for petitioner.

Dale A. Zusi and Michael F. Steiner, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge:

In a notice of deficiency addressed to

petitioner and Barbara G. Helwig,1 respondent determined income

tax deficiencies as follows:

1

Petitioner and Barbara G. Helwig filed a joint petition,

but Barbara G. Helwig’s cause of action was severed from that of

petitioner.

- 2 Amount

$57,405

178,902

132,150

142,110

Year

1990

1991

1992

1993

The amounts remaining in controversy, in great part, derive from

questions about whether petitioner’s S corporation’s claimed

deductions for losses and interest are allowable.

In particular,

the controversy involves whether advances from the S corporation

to a second corporation constitute debt or equity.

If the

advances are held to be debt, then we must decide whether it was

business debt and whether it became worthless as claimed.

We

also decide whether petitioner is entitled to deduct interest

paid on indebtedness incurred to purchase a yacht.

FINDINGS OF FACT2

Petitioner resided and/or conducted business in the State of

California, at the time his petition was filed.

During the years

in issue, petitioner was the sole shareholder of K&H Finishing,

Inc. (K&H), an S corporation.

In 1966, K&H began providing

painting services to computer manufacturers in the Silicon

Valley, California, area.

As the business matured and through

the years before the Court, K&H would purchase and inventory

parts, assemble and finish them, and then sell and deliver them

to the manufacturer/customer.

2

Although K&H did not place the

The parties’ stipulations of facts and exhibits are

incorporated by this reference.

- 3 computer components into the enclosures it painted, occasionally,

K&H installed electric wiring or cable into the enclosures.

By the early 1990's, K&H’s contracts were becoming larger,

but the industry was also becoming more competitive, and the type

of computer enclosure was changing to molded materials that did

not require painting, thus reducing the need for K&H’s services.

As of 1990, K&H operated in a 65,000-square-foot facility, with

150 employees, and petitioner, as president, earned an annual

salary ranging from $276,040 to $1,318,813 during the years 1990

through 1993.

Due to the changes in the industry, K&H sought

labor-intensive work and advertised that it did material

handling, scheduling, and quality control for different

materials, including sheet metal fabrication and plastic forming

and injection molding.

Other ways in which K&H was able to secure a larger portion

of the market were to perform complete or “turn-key” projects and

to assist its customers financially by purchasing the parts and

providing financial float for customers while petitioner was

performing its services.

On occasion, K&H advanced cash and

acted as a guarantor for third parties.

In some of those

instances, petitioner had an equity interest in the borrowing

entity.

K&H also “invested” time and expended capital in a

project with a company known as PolyTracker, which was attempting

to develop a locking shopping cart wheel.

If successful, K&H

- 4 would have manufactured the wheel, and its profits might have

permitted K&H to recoup its costs.

The level of production

necessary to permit K&H to recoup its costs was never achieved.

When K&H purchased materials to fulfill contracts with

customers, to the extent that it had not been repaid and/or had

not yet billed the customer, K&H either treated the outstanding

amount as an asset or advance to the customer or, if it pertained

to research and development, claimed it as an expense.

In one instance, K&H, at its own expense, built a dedicated

facility for Apple Computer (Apple), and then recouped its

capital outlay by means of a production contract with Apple.

K&H

built conveyance, assembly, and painting equipment, and purchased

the enclosures that were delivered to K&H’s facility where they

were assembled, coated and/or painted, and then shipped to Apple.

The sales of the product to Apple permitted the recoup of its

capital outlay and also produced a 15-percent profit for K&H.

Hot Snacks, Inc. (Snacks), a C corporation, in January 1988,

commenced a business with the goal of creating a computercontrolled vending machine that would dispense a french fried

product, freshly fried in oil.

One of K&H’s employees brought

the opportunity in Snacks to petitioner’s attention.

This

opportunity was part of K&H’s attempt to find new customers and a

source for revenue.

Petitioner invested $120,000 in Snacks at a

time when a prototype of the computer-controlled vending machine

- 5 existed.

As of July 1989, petitioner owned 88 percent of the

outstanding shares of Snacks stock.

Petitioner’s accountant and

the accountant’s wife jointly invested $100,000 in exchange for 4

percent of Snacks stock.

In addition to petitioner’s and his

accountant’s stock ownership in Snacks, during 1990, new

investors Donald Parker purchased 5 percent of Snacks stock for

just over $150,000, and Al Marquez obtained 3 percent of Snacks

stock with a value exceeding $100,000.

Petitioner and the accountant had begun their professional

relationship during 1974.

During 1993, although the accountant

believed that Snacks would not be successful, he also believed

that the vending machine patent could have residual value for

future development and decided to pay petitioner $5,000 for

petitioner’s shares in Snacks.

That sale caused petitioner to

claim a $115,000 loss, $100,000 of which was claimed as an

“ordinary” loss under section 1244.3

This loss is not presently

at issue before the Court.

Snacks entered into a relationship with K&H involving the

development and manufacture of a vending machine.

Expecting to

be repaid, K&H incurred costs in attempting to develop a

merchantable vending machine.

3

Petitioner was designated as

Section references are to the Internal Revenue Code as

amended and in effect for the years under consideration. Rule

references are to this Court’s Rules of Practice and Procedure.

- 6 president of Snacks and was given authority to deal directly with

K&H in accord with certain waivers that were made by Snacks’

shareholders.

Snacks had also entered into joint venture

agreements with Korean companies for certain aspects of the

manufacture of the vending machines to be used in Southeast Asia.

K&H advanced cash to Snacks, and each such advance was

formalized in a promissory note due 1 year from its date of

execution.

The notes, signed by petitioner on behalf of Snacks,

were dated from June 1988 through August 1993, and totaled

$1,880,000.

Generally, the advances were used for Snacks’

operating expenses.

The advances were carried on Snacks’ and

K&H’s financial records and K&H’s tax returns as loans or debt.

K&H, on its Federal income tax returns, reported interest income

from the notes.

A foreign company paid Snacks $600,000 for a

license to sell the vending machine in a particular locality, and

from that $300,000 was repaid to K&H during June 1990.

Other

than the $300,000 repayment, no other repayments were made, and

no attempt was made to collect the balance because Snacks was

unprofitable.

K&H expected to earn income and profits from its

relationship with Snacks by assembling vending machines.

It was

estimated that K&H would make $500 per vending machine and that

there would be a 100,000-unit market demand, resulting in

- 7 projected income of $50 million for K&H.

K&H was not directly

involved in the research and development of the vending machine.

K&H determined the amount of partial worthlessness of the

advances made to Snacks each year by comparing the prior year’s

ending advance balance with Snacks’ cumulative losses to arrive

at a ratio.

The resulting ratio was then applied to the prior

year’s ending advance balance to arrive at the claimed writeoff.

Snacks’ net worth as of July 31, 1990, 1991, 1992, 1993, and 1994

was a negative $1,244,172, $2,107,158, $2,571,348, $3,019,739,

and $3,126,138, respectively, each caused by an excess of

liabilities over assets.

For its fiscal years ended April 27,

1991, and April 25, 1992, K&H claimed that the advances to Snacks

had become partially worthless (a bad debt) and deducted the

amounts of $579,607 and $461,970, respectively.

Respondent, in

the notice of deficiency, determined that the claimed bad debt

deductions were not allowable.

K&H advanced Snacks more than $700,000 through April 1990

and additional amounts of $320,000 and $260,000 during the fiscal

years ended April 1991 and 1992.

For the period ended December

31, 1993, K&H, based on the accountant’s advice, sold to the

accountant $650,000 of the notes for $1,000 in an attempt to “fix

the time and amount of the loss.”

Respondent determined that the

- 8 $649,000 ordinary loss deduction claimed by petitioner for 1993

was not allowable.

For its 1990, 1991, 1992, and 1993 fiscal years, K&H paid

interest on indebtedness incurred to purchase a yacht in the

amounts of $20,659, $20,280, $17,515, and $11,950, respectively.

OPINION

The principal and threshold question for our consideration

is whether the advances from K&H to Snacks were debt or equity,

thereby determining the proper deduction, if any, allowed to

petitioner as sole shareholder of K&H, a pass-thru entity.

If we

find that the advances are debt, we must consider whether the

debt was business debt and became worthless as claimed.

In the

setting of this case, the answer to the debt versus equity

question will decide whether the claimed losses are ordinary or

capital, if allowable.

Some of the factors that we consider here

in deciding whether advances are debt or equity include:

The

existence of debt instruments; the parties’ intent and their

representations of the advances; the existence of fixed maturity

dates; rights to enforce payment; whether the advances enhanced

participation in the debtor’s management; the status of the

advances relative to other creditors; whether the borrowing

entity is thinly capitalized; repayment activity; and the type of

expenditures made with the advances.

See, e.g., Dixie Dairies

- 9 Corp. v. Commissioner, 74 T.C. 476, 493-494 (1980); Cerand & Co.

v. Commissioner, T.C. Memo. 1998-423; see also Estate of Mixon v.

United States, 464 F.2d 394, 398 n.1 (5th Cir. 1972); A.R. Lantz

Co. v. United States, 424 F.2d 1330 (9th Cir. 1970).

The facts and circumstances of each case must be considered,

and no single factor is considered determinative.

Co. v. Commissioner, 326 U.S. 521, 530 (1946).

See John Kelly

Ultimately, we

must decide whether K&H intended to create a debt with a

reasonable expectation of repayment and whether those aspects

comported with economic reality.

Commissioner, supra.

See Cerand & Co. v.

There can be no doubt that the form in

which the advances were cast was debt and not equity.

There is

also no doubt that the parties treated the advances as debt.

Each advance was memorialized by a promissory note, bearing a

fixed rate of interest, and due 1 year from its execution.

In

addition, each of the parties to the notes recorded the

accumulated balances as debts or loans on books and records and

financial statements.

It is also clear that, for tax purposes,

each party consistently reported the advances as debt, and K&H

reported interest income attributable to the notes.

In the face of petitioner’s strong position on the form of

the transactions, respondent contends that, in substance, the

advances were equity in nature.

In support of this contention,

- 10 -

respondent points out that only petitioner and no other

shareholder signed the notes, and no efforts were made to collect

matured notes.

Petitioner counters that he was given authority

and consent by the other shareholders.

Petitioner also points

out that the fact that petitioner signed all the notes does not

link the advances to petitioner’s capital investment in Snacks.

Petitioner also explains that the failure to enforce collection

on mature notes was not due to a legal inability, but instead to

the knowledge that Snacks was not in a position to pay.

In

addition, petitioner points out that Snacks repaid K&H $300,000

when funds became available because of a transaction with a

foreign licensee.

That repayment, petitioner contends, is “clear

evidence” of debt and not equity.

Respondent also argues that the advances were used to pay

the day-to-day operating expenses in a setting where Snacks had

not been shown capable of generating profit.

This aspect,

respondent contends, means that the repayment advances are placed

at the “risk of the business”, meaning, ostensibly, that the

advances represent capital and not debt.

otherwise.

Petitioner has shown

At the time petitioner paid $120,000 for share

holdings in Snacks, a prototype of the vending machine existed.

There was active development of the product and its marketplace

throughout the period under consideration.

After petitioner

- 11 -

invested in Snacks, foreign businesses became interested in the

vending machine, and during 1990 other investors acquired several

hundred thousand dollars of Snacks’ stock representing

substantially smaller percentages of the Snacks shares than those

acquired by petitioner.

In addition, Southeast Asian

manufacturing companies entered into a joint venture agreement in

connection with the vending machines’ manufacture and sales in

their geographical area.

Those facts represent independent

evidence of perceived potential for Snacks to be profitable.

Accordingly, petitioner’s belief as to the potential

profitability of Snacks is confirmed by the actions of other

lenders and business interests who became involved with Snacks on

the same or similar terms as K&H and petitioner.

These factors

also bolster the estimates that there was potential for K&H to

earn substantial profits (projected at 100,000 machines and

profit of $500 per machine or $50 million).

The facts and circumstances in this case reflect that Snacks

was not thinly capitalized and that the advances were in form and

substance debt with a reasonable expectation of repayment.

Accordingly, we hold respondent’s determination, that the

advances were equity, to be in error.

- 12 -

Next, we consider whether the loans to Snacks were business

or nonbusiness as they related to K&H.4

Section 166, which

permits deductions for bad debts, distinguishes between business

and nonbusiness bad debts.

Income Tax Regs.

See sec. 166(d); sec. 1.166-5(b),

A partial or wholly worthless business bad debt

may be deducted, whereas only a wholly worthless nonbusiness bad

debt is deductible.

See sec. 166.

To qualify as a business bad

debt, it must be established that the debt was proximately

related to the conduct of the taxpayer’s trade or business.

See

United States v. Generes, 405 U.S. 93, 103 (1972); sec. 1.1665(b), Income Tax Regs.

Whether a debt is proximately related to a trade or business

is dependent upon a taxpayer’s dominant motive for lending the

money.

See United States v. Generes, supra at 104.

A taxpayer’s

dominant motive must be business related, as opposed to

investment related, for a loan to be proximately related to the

taxpayer’s trade or business.

See Putoma Corp. v. Commissioner,

66 T.C. 652, 673 (1976), affd. 601 F.2d 734 (5th Cir. 1979);

United States v. Generes, supra.

Petitioner contends that the dominant motivation for the

loans was developing business opportunities for K&H by

4

We consider the business versus nonbusiness question next

because petitioner, through K&H, seeks to claim losses due to

partial worthlessness, a treatment that is not available for

nonbusiness bad debts. See sec. 166(d)(1)(B).

- 13 -

involvement in the manufacture of vending machines.

Conversely,

respondent contends that the securing of future business was not

the dominant motive.

Respondent argues that the potential for

profit from the appreciation of Snack share holdings was the

dominant motive for K&H advancing funds to Snacks.5

To some

extent, we have tangentially addressed this question by holding

that K&H’s advances to Snacks were debt (loans) rather than

equity.

In addressing the debt versus equity question, we have

already decided that the advances were not equity and were not

investment motivated.

Petitioner, who earned substantial salaries from K&H,

realized that competition had forced his company to seek out

additional business and provide incentives for potential or

existing customers.

One of the ways that K&H accomplished this

was to either advance money to or lessen the financial burden of

customers.

Leading up to and during the years in issue, K&H lent

funds, purchased inventory and provided float for customers, and

built manufacturing facilities to address customers’ needs.

The

transaction with Snacks fit within that pattern of K&H’s business

activity.

There was business potential and reasonable

expectation of profit for K&H in its relationship with Snacks.

5

We note that neither party makes distinctions between

petitioner and his wholly owned S corporation. For example,

respondent connects petitioner’s share ownership with his S

corporation’s advances.

- 14 -

That potential was corroborated by unrelated third parties.

We

find that K&H’s dominant motive for advancing or lending Snacks

funds was for the purpose of developing business opportunities

and that the debt was thus proximately related to its trade or

business.

Accordingly, we hold that the advances in question

were business bad debts within the meaning of section 166.

The final step in this three part inquiry is to decide

whether petitioner has shown that any portion of the business bad

debts became worthless during the years claimed by petitioner.

This inquiry is also one of facts and circumstances, and

worthlessness occurs “in the year in which identifiable events

clearly mark the futility of any hope of further recovery”.

James A. Messer Co. v. Commissioner, 57 T.C. 848, 861 (1972).

Portions of the business bad debt were written off as

partially worthless for the 1991 and 1992 fiscal years.

The

amounts of partial worthlessness were computed by means of a

ratio generated by comparing the total losses of Snacks to the

outstanding balance of the advances (both of which were

increasing annually).

Because the vending machines’ capability

depended on its computer hardware and software, the accountant

considered the known propensity of these items to become

technologically outmoded in choosing the method to compute

worthlessness and in reaching the conclusion that loss deductions

- 15 -

should be claimed.

Snacks had a negative net worth for its 1991

and 1992 years of $2,107,158 and $2,571,348, respectively.

Snacks’ negative net worth was steadily increasing throughout the

period under consideration.

The remaining $650,000 in

outstanding notes was sold to the accountant, in a transaction

for convenience, for $1,000 during the 1993 year.

Also in 1993,

petitioner sold his stock holdings in Snacks for $5,000 to the

accountant and claimed a $100,000 capital loss deduction.

At

that time, petitioner owned about 80 percent of Snacks.

Respondent’s focus with respect to the worthlessness

question concerns the fact that K&H continued to make advances

during the 1991 and 1992 period for which bad debt loss

deductions were claimed.

Relying on two memorandum opinions of

this Court, respondent argues that continued extension of credit

is not consistent with the claim of worthlessness.

One of those

opinions involved a taxpayer who was reselling a substantial

percentage of its purchases to an insolvent customer.

In that

case, the holding that the taxpayer was not entitled to claim

partial worthlessness was based on the fact that the customer was

deeply insolvent and that its situation did “worsen markedly,”

and the taxpayer continued to sell a significant amount of

merchandise (extend credit) to the customer.

Inc. v. Commissioner, T.C. Memo. 1958-203.

See Veego Foods,

The other opinion

- 16 -

relied on by respondent involved a situation where the taxpayer

claimed partial worthlessness where the debtor’s liabilities were

seven times its assets.

claim, found:

The Court, in denying the taxpayer’s

That although the liabilities exceeded assets by a

ratio of 7 to 1, the assets had considerable value; in the year

of the taxpayer’s claim and the following year the debtor made

repayments, and the repayments continued until the debt was

reduced to an amount smaller than claimed loss.

See Miller

Realty Co. v. Commissioner, T.C. Memo. 1977-440.

In petitioner’s circumstances, Snacks’ negative net worth

was steadily increasing.

The increases during the 1991, 1992,

and 1993 periods, however, were to some great extent attributable

to advances from K&H.

More importantly, petitioner has not shown

any identifiable events that “clearly mark the futility of any

hope of further recovery.”

The accountant’s purchase of the

notes for a nominal amount was a transaction for convenience and

as a courtesy to petitioner, and did not evidence the

worthlessness of the notes.

We also agree with respondent’s

observation that K&H’s continued extension of credit is not

consistent with the claim of worthlessness.

Although the

advances are business debt within the meaning of section 166, no

portion of them became worthless during petitioner’s 1991, 1992,

or 1993, taxable year.

We also note that even if the sale of the

- 17 -

notes to the accountant for $1,000 evidenced the worthlessness of

the notes, that sale did not occur until December 21, 1993, at

the conclusion of K&H’s 1993 year and, hence, petitioner’s 1993

tax year.

In addition, petitioner’s sale of his capital or

equity interest in Snacks has not been shown to have had any

particular effect on the worthlessness of the notes.

Accordingly, we find that petitioner has not substantiated his

claim for partial worthlessness of the notes during the years in

question.

Two remaining issues were addressed by the parties on

brief.6

The first involved $60,143 of Snacks’ operating expenses

that were paid and claimed by K&H for its taxable year ended

April 27, 1991.

Respondent determined in the notice of

deficiency that the expenses “are not deductible because * * *

[they] were incurred on behalf of * * * [Snacks] and therefore

are not trade or business expenses of K&H”.

On brief, respondent

maintained the position that the expenses were not K&H’s trade or

business expenses.

Generally, one taxpayer may not deduct expenses paid on

behalf of another taxpayer.

See, e.g., Dietrick v. Commissioner,

881 F.2d 336, 339 (6th Cir. 1989), affg. T.C. Memo. 1988-180.

6

We

To the extent that either party did not address an issue

raised by the pleadings, we assume that the issue has either been

agreed to by the parties or is being abandoned by the party with

the burden of proof.

- 18 -

have held that in certain limited circumstances a taxpayer may

deduct the expenses of another taxpayer.

Commissioner, 48 T.C. 679, 688 (1967).

See Lohrke v.

For the application of

our holding in Lohrke, we must first ascertain K&H’s motive for

paying Snacks’ operating expenses and then determine whether it

was in furtherance or promotion of K&H’s trade or business.

See

id.

Our consideration of whether the advances here were debt or

equity and business or nonbusiness debts covered the question of

whether the advances were to promote K&H or whether they were

investment in Snacks.

That is the same inquiry that is called

for under the above-stated Lohrke standard.

Because K&H’s

relationship with Snacks was to secure additional business and

profits for K&H, it follows that K&H’s payment of Snacks’

operating expenses in this limited setting would be deductible by

K&H.

Accordingly, petitioner, through K&H, is entitled to the

$60,143 deduction for his 1991 taxable year.

The final item addressed by the parties’ briefs concerns

respondent’s disallowance of interest paid by K&H on indebtedness

incurred to purchase a yacht.

The amounts disallowed for

petitioner’s 1990 through 1993 taxable years are $20,659,

$20,280, $17,515, and $11,950, respectively.

- 19 -

The record consists of only two exhibits that pertain to

these adjustments.

One exhibit, a security agreement, reveals

that during 1989, a used 1985 Carver boat was purchased, and

$200,250 of the purchase price was financed.

Attached to the

agreement is an amortization schedule showing a breakdown of the

principal and interest to be paid.

The other exhibit is a

December 1, 1994, memorandum from petitioner’s accountant’s

office to respondent’s agent.

The memorandum contains summarized

information provided by the accountant pursuant to the request of

respondent’s agent.

The memorandum contains the following

pertinent statements about the yacht:

7) Business purpose and expenses of Yacht - Per Ed

Helwig, the boat (yacht is a misnomer as the vessel is

42 foot trailer-able boat) is used to entertain

customers. As the boat is not docked in a slip, but is

parked at his house, there are no monthly expenses

related to maintenance.

*

*

*

*

*

*

*

Pursuant to Sec. 274 the boat is not depreciated for

federal income tax purposes. Any expenses related to

the entertainment of customers on the boat are out-ofpocket costs reimbursed to E.A. Helwig by the

corporation or corporate credit card charges, both of

which are charged to the meals and entertainment

accounts and limited to 80% deductible. A “schedule of

use” is not available.

Based on the above, respondent contends that no deduction is

allowable for any expenditure paid with respect to an

entertainment facility after December 31, 1978, pursuant to

- 20 -

section 274(a)(1)(B) and section 1.274-2(a)(2)(i), Income Tax

Regs.

Respondent further contends that pursuant to sec. 1.274-

2(e)(4)(iii), Income Tax Regs., a yacht is considered an

entertainment facility.

Petitioner, does not question respondent’s contention, but

instead counters that the interest deduction is allowable under

section 274(f).

That section, entitled “INTEREST, TAXES,

CASUALTY LOSSES, ETC.,” exempts from the section 274 requirements

“any deduction allowable to the taxpayer without regard to its

connection with his trade or business”.

With respect to

corporations (taxpayers who are not individuals), section 274(f)

is to be applied as though the taxpayer was an individual.

In

that regard, respondent argues that unless petitioner can show an

exception to the general rule of section 163(h) that an

individual’s personal interest is not deductible, no deduction is

permissible.

Petitioner simply argues that the language of section 163(h)

“In the case of a taxpayer other than a corporation,” no personal

interest is allowable, would cause the allowance of an interest

deduction because K&H is a corporation.

If this were simply a

matter of applying section 163(h), petitioner’s argument would

ring truer.

The section 274 limitations outlined above, however,

specifically address this situation.

Those limitations cause

- 21 -

petitioner and/or his S corporation to be treated as an

individual.

Accordingly, petitioner is not entitled to deduct

interest on the indebtedness to acquire the yacht under section

163(h), either in his own right or through his corporation.

To reflect the foregoing and because of concessions by the

parties,

Decision will be entered

under Rule 155.