# UNITED STATES TAX COURT

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## Record

- **Collection:** Agency decision
- **Document type:** Agency decision

## Text

34
DRC

T.C. Memo. 2017-1

UNITED STATES TAX COURT

JOHN M. SENSENIG AND ALTA Z. SENSENIG, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 16254-11.

Filed January 3, 2017.

P-H was the sole shareholder and president of CLCL, an
S corporation. CLCL provided high-risk capital to various
companies, including G-L, LFP, and WSC. P-H also owned an equity
interest in each of G-L, LFP, and WSC. No loan documents were
created for the advances to the three corporations; P-H did not
undertake "due diligence" analysis of borrowers that a typical creditor
would have undertaken; CLCL made the advances notwithstanding
WSC's other superior creditors; and P-H never attempted to collect
repayment of the advances. P-H claimed a bad debt deduction for
CLCL on CLCL's Form 1120S, "U.S. Income Tax Return for an S
Corporation", for 2005. The Form 1120S did not identify the source
of the deduction; but during R's examination, P-H stated it was for
alleged loans to G-L and LFP. In this litigation Ps alleged that the
bad debts arose from loans to WSC rather than to G-L and LFP.
H_eld: The advances by P-H through CLCL were not loans but
investments in equity, and they did not become worthless in 2005.
Therefore Ps are not entitled to a business bad debt deduction for
2005.

SERVED Jan 03 2017

-2[*2]

He]4, further, Ps are liable for an accuracy-related penalty
under I.R.C. sec. 6662(a).

John M. Sensenig and Alta Z. Sensenig, for themselves.
Kristina L. Rico, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION
GUSTAFSON, Judge: Pursuant to section 6212(a),¹ the Internal Revenue
Service ("IRS") determined deficiencies in the 2003, 2004, and 2005 income tax
of petitioners, John M. Sensenig and Alta Z. Sensenig, as well as accuracy-related
penalties under section 6662(a) for all three years and an addition to tax under
section 6651(a)(1) for 2003. The Sensenigs filed a timely petition under section
6213(a) which stated that they "appeal the IRS findings". We construe this pro se
petition to request, for all three years, redetermination of the tax, penalties, and
(for 2003) the addition to tax. At the time they filed the petition, they resided in
Pennsylvania.

¹Unless otherwise indicated, all section references are to the Internal
Revenue Code (26 U.S.C.), as amended, and all Rule references are to the Tax
Court Rules of Practice and Procedure. All amounts are rounded to the nearest

dollar.

-3[*3] After concessions by the parties,2 the issues to be decided are: (1) whether
the Sensenigs are entitled to a business bad debt deduction of $10,695,581 for
2005 (we hold that they are not); and (2) whether the Sensenigs are liable for the
accuracy-related penalty for 2005 (we hold that they are).

FINDINGS OF FACT
I.

Mr. and Mrs. Sensenig

Mr. Sensenig is an entrepreneur and a self-taught licensed public
accountant, and Mrs. Sensenig is a homemaker. Mr. Sensenig has prepared tax
returns since 1972, received his license in December 1978, and maintained his
license into the 1990s. Mr. Sensenig owns his own tax return preparation
business, Group Support, Inc., an S corporation. At one time Mr. Sensenig
prepared approximately 300 personal and business Federal tax returns a year,
2In September 2014 the parties filed a "Stipulation of Settled Issues" that
addresses certain adjustments in the notice of deficiency and concludes (in
paragraph 10): "The remaining items at issue in this case are whether petitioner is
entitled to the claimed Schedule E bad debt in the amount of $10,695,581 claimed
in taxable year 2005 and whether the addition to tax under I.R.C. § 6662 apply."
Paragraph 5 of the "First Stipulation of Facts" filed at trial in June 2015 states that
"[t]he parties entered into a stipulation of settled issues that resolved all of the
issues for the taxable years 2003 and 2004." In view of respondent's burden of
production under section 7491(c), and in view of the silence of both respondent's
pretrial memorandum and his post-trial brief on the penalty issue for 2003 and
2004 and the addition to tax under section 6651(a)(1), we construe the stipulation
to resolve in the Sensenigs' favor the penalties for 2003 and 2004 and the addition

to tax for 2003.

-4[*4] including all of his own Federal income tax returns as well as all the Federal
tax returns for the companies in which he had an equity interest.
II.

Conestoga Log Cabin Leasing, Inc.
Over the last 30 years, Mr. Sensenig has had an equity interest in a number

of companies, including S corporations named Conestoga Log Cabins and
Conestoga Log Cabins Leasing, Inc. ("CLCL"). Mr. Sensenig served as president
of CLCL; and by 2005 he was its sole owner and the sole signatory of its bank
accounts. Conestoga Log Cabins was in the business of selling log cabin kits and
log home kits. CLCL was first organized as a manufacturer of the log cabin kits
sold by Conestoga Log Cabins, but CLCL later provided financing to buyers who
could not afford to pay for the kits outright. The funds used to finance these
purchases came from Mr. Sensenig's investor pool.
III.

Investor pool
Mr. Sensenig solicited investments in the CLCL financing activity by other

Mennonite and Amish individuals. The investors were promised attractive rates of
return by demand notes payable by Mr. Sensenig individually or by CLCL. The
notes bore interest rates but no maturity dates. Initially these invested funds were
used only to finance log cabin purchases; but because numerous Amish and
Mennonite investors became interested in investing funds with Mr. Sensenig, he

-5[*5] began accepting additional funds (and executing demand notes with favorable
interest rates) to invest in other companies.
Mr. Sensenig, through CLCL, advanced money to start-up companies and to
companies already in existence that had an opportunity for a new product or line
of business. Mr. Sensenig never reviewed formal written projections for the
companies that CLCL invested in. Mr. Sensenig did not obtain any third-party
audits or request any financial statements, and CLCL did not finance any company
if that company had other means to borrow, such as traditional banking.
Mr. Sensenig stated that he relied on "gut feel" as to when something made
financial sense and preferred being able to "turn on a dime"; and he acknowledged
at trial that CLCL provided "high-risk capital" and that it was "an investment
business".
In return for the money CLCL advanced, Mr. Sensenig acquired an equity
interest in the company (apparently a minority interest in most or all cases); and
Mr. Sensenig acquired financial control over each of the companies that CLCL
invested in by becoming a director, a bank account signatory, and the chief
financial officer. Thereafter he prepared the tax returns for the company.
Repayment of amounts advanced by CLCL to a company was not
anticipated until the project had been "completed", unless there was a surplus

-6[*6] (which CLCL never had). CLCL and Mr. Sensenig never charged a
commission or fee for services to any of the invested-in companies.
Mr. Sensenig eventually raised investments totaling in excess of $50 million
from numerous investors, primarily through a small advertisement in a
Pennsylvania Dutch newspaper.
Mr. Sensenig maintained detailed account records for each investor, sent the
investors quarterly statements reporting interest accrued, and issued to them
Forms 1099. The investors did not have a say in where Mr. Sensenig or CLCL
invested their money, and there was no formal approval or voting process as to
what companies or projects Mr. Sensenig or CLCL chose for investment.
IV.

2005 Investments

In 2005 Mr. Sensenig, through CLCL, invested in 15-20 different
companies. Three of these are relevant to the parties' dispute about the Sensenigs'
claim of a 2005 bad debt loss:

A.

Glue-Lam, Inc.

Glue-Lam, Inc. ("G-L"), was organized in 1999 as a C corporation to design
and manufacture glue-laminated timber. As late as 2005, G-L's lamination
process was still under development, and the product was never manufactured.
Mr. Sensenig had an equity interest in G-L, and during taxable years 2003 through

-7[*7] 2005, CLCL advanced approximately $1,481,000 to G-L. The other
shareholders of G-L contributed one dollar each to G-L's capital.
Mr. Sensenig was appointed a director, the chief financial officer, the
bookkeeper, and the paymaster of G-L, and he was made a signatory of G-L's
accounts. Mr. Sensenig never received a salary. Mr. Sensenig stipulated that his
goal for his investment in G-L was to profit from his ownership interest.
Although the records of CLCL included journal entries labeling some of
CLCL's advances to G-L as "loans", neither Mr. Sensenig nor CLCL executed any
notes, agreements, or other documents with G-L evidencing any loan. According
to its tax returns, G-L continued to acquire assets through 2005.

Mr. Sensenig has not provided any evidence that CLCL ever held G-L in
default, and Mr. Sensenig admits he never demanded repayment of these advances
from G-L. Mr. Sensenig did not take legal action against G-L because of his
status as a shareholder as well as his Mennonite religious views. There is no
documentary evidence that CLCL wrote off any portion of the G-L debts on its
books in 2005. Mr. Sensenig stated that the only evidence would be on the tax
returns themselves.
G-L was still operating after 2005 (the year of the claimed bad debt loss),
and for several years CLCL continued to advance money to G-L. The records

-8[*8] reflect that in 2006 CLCL advanced $800,000, that in 2007 CLCL advanced
another $950,000, and that in 2008 CLCL advanced an additional $1 million.
Some portion (which we cannot quantify) of the funds advanced in those years
reflects an increase in amounts of interest that G-L owed to CLCL, which CLCL
accrued but which G-L did not pay.
As late as June 2010, G-L had an active Web site. G-L's final Federal
income tax return was filed for taxable year 2011. As late as May 2015, G-L was
listed as "Active" on the Pennsylvania Department of State Web site.
B.

Lebanon Finished Products

Lebanon Finished Products ("LFP") was organized in 2001 as an
S corporation and was in the business of polishing rebar. CLCL purchased equity
in LFP because Mr. Sensenig thought one of its employees had a good idea for
constructing a machine to "electro polish." Since LFP did not have sufficient
capital to develop the product, Mr. Sensenig purchased a 33% equity interest in
LFP. During taxable years 2003 through 2005, CLCL advanced $1,476,000 to

LFP.
No further equity contributions were made by anyone else. Mr. Sensenig
was appointed a director, the chief financial officer, the bookkeeper, and the
paymaster of LFP, and he was made a signatory of LFP's accounts. Mr. Sensenig

-9[*9] did not receive a salary from LFP, and his stated goal for CLCL's investment
in LFP was to profit from its ownership interest.
Neither Mr. Sensenig nor CLCL executed with LFP any documentation
evidencing any loan. As with G-L, Mr. Sensenig did create, on CLCL's records,
journal entries that labeled some of the advances from CLCL to LFP as "loans".
According to its tax returns, LFP continued to acquire assets through 2005.
Mr. Sensenig has not provided any evidence that CLCL held LFP in default,
and Mr. Sensenig never demanded repayment of these advances from LFP. Mr.
Sensenig did not take legal action against LFP because of his status as shareholder
of LFP, as well as his religious views. There is no documentary evidence that
CLCL wrote off any portion of the LFP debts in 2005 on its books. After 2005
LFP was still operating.
The record reflects that in 2006 (the year after the claimed bad debt loss)
CLCL advanced approximately $1.2 million to LFP, of which approximately
$700,000 represented accrued but unpaid interest. During 2007 CLCL continued
to finance LFP because Mr. Sensenig hoped that LFP could obtain a patent. As
late as May 2007 LFP had an active Web site, and as late as May 2015 LFP was
listed as "active" on the Pennsylvania Department of State Web site.

-10[*10] C.

Washington Street Castings

Washington Street Castings ("WSC") was organized in 2001 as an
S corporation and operated a foundry on a large plot of land that Mr. Sensenig
considered ideal for development. WSC had financed its land acquisition by
obtaining loans from unrelated third-party sources, and Mr. Sensenig
acknowledged that these lenders had a claim to that property superior to CLCL's
claim. At some point after WSC's land acquisition, Mr. Sensenig through CLCL
bought a 25% equity interest in WSC. WSC continued operating the existing
foundry.

In December 2003 the shareholders of WSC entered into an "Authorizing
Resolution", by which the president of WSC was authorized to borrow money or
obtain extensions of credit from CLCL. According to the resolution, the president
of WSC was authorized "to execute all documents, instruments and agreements as
may be required by the Lender [CLCL] to fulfill the conditions of any loan
agreement, note, mortgage or other financing document", but no such documents
were ever executed.
During taxable years 2003 through 2005, CLCL advanced $2,031,500 to
WSC. Mr. Sensenig was appointed a director, the chief financial officer, the
bookkeeper, and the paymaster of WSC, and he was made a signatory of the

-11[*11] company's accounts. Mr. Sensenig did not receive a salary from WSC.
Mr. Sensenig's stated goal for his investment in WSC was to profit from his
ownership interest.
As with G-L and LFP, Mr. Sensenig did create on the records of CLCL
journal entries that labeled some of the advances from CLCL to WSC as "loans".
CLCL did not hold WSC in default, and Mr. Sensenig has never made formal
demands for repayment from WSC. Mr. Sensenig asserts that because he was an
insider wearing several hats, no formal demands were necessary. Mr. Sensenig
did not take legal action against WSC because of his status as a shareholder of
both companies as well as his religious beliefs.
There is no documentary evidence that CLCL wrote off any portion of the
WSC debts on its books in 2005. After 2005 WSC was still in operation. In 2006
CLCL advanced an additional $1.4 million to WSC, of which approximately
$44,000 represented accrued but unpaid interest; and again in 2007 CLCL
advanced approximately $1.1 million to WSC. As late as May 2015, WSC was
listed as "Active" on the Pennsylvania Department of State Web site.
V.

Investigation by securities regulators
The Pennsylvania Securities Commission ("PSC") investigated

Mr. Sensenig's receipt of funds borrowed from his investors. The PSC determined

-12[*12] that Mr. Sensenig's practice of issuing demand notes to investors in return
for receipt of borrowed funds constituted the sale of unregistered securities. In
June 2005 Mr. Sensenig and CLCL received from the PSC an order to cease and
desist the offering and sale of unregistered securities. As a result, Mr. Sensenig
was barred from accepting any more money into the investor pool, and he lacked
funds to advance to the not-yet-completed projects from which he had expected
eventually to pay off the demand notes. He perceived this as a dire threat to
CLCL, its investors, and its investments.
In January 2006 the PSC accepted Mr. Sensenig's offer of settlement and
rescinded the summary order to cease and desist. Mr. Sensenig and CLCL were
permanently barred from offering or selling securities in Pennsylvania unless he
received a valid registration statement. Thereafter, Mr. Sensenig took steps to try
to register with the U.S. Securities and Exchange Commission, but it proved too
costly and he abandoned the effort.
VI.

The 2005 tax returns

In 2006 Carl Smith, a certified public accountant ("C.P.A.") employed by

Group Support, Inc., prepared CLCL's 2005 Form 1120S, "U.S. Income Tax
Return for an S Corporation". While doing so, he recommended that CLCL
deduct $10,695,581 as bad debt. The Form 1120S does not identify the source of

-13[*13] the bad debt deduction; but according to CLCL's general ledger for January
1 through December 31, 2005, the total bad debt as of December 31, 2005, was

$10,695,581, which included $4,917,529 attributable to G-L and $5,150,533
attributable to LFP. Mr. Sensenig followed this recommendation because he and
Mr. Smith believed the possibility either company would become profitable was
remote. Mr. Sensenig signed the 2005 CLCL Form 1120S that Mr. Smith
prepared. Apart from the bad debt deduction, CLCL would have reported ordinary
business income for 2005 in the amount of $2,741,526; but instead CLCL's
Form 1120S reported a net loss, after the bad debt deduction, of $7,954,055.
Mr. and Mrs. Sensenig filed their 2005 Form 1040, "U.S. Individual Income
Tax Return", on October 16, 2006. For reasons the record does not show, they did
not claim on their return any portion of CLCL's reported loss.
VII.

The Commissioner's examination
The IRS examined CLCL's and the Sensenigs' tax returns for 2003 through

2005. On May 8, 2007, the Commissioner's revenue agent toured G-L and LFP;
both companies were still in existence at that time, but only LFP was still
operating at the time of the facility tour. On May 24, 2007, the IRS requested
documents and information from Mr. Sensenig regarding the bad debt deduction
claimed for G-L and LFP. Two days later, Mr. Smith met with the revenue agent

-14[*14] to discuss the IRS's information document request ("IDR"), and at the
meeting Mr. Sensenig provided the agent with a one-page written explanation of
the "2005 Bad Debt Write Offs". That document stated that the loans for which
CLCL claimed a bad debt deduction were to G-L and LFP. During Mr. Sensenig's
examination, no companies other than G-L and WSC were mentioned as having

deductible bad debts.
On June 21, 2007, the IRS again requested information and documents
regarding the claimed bad debt deduction attributable to G-L and LFP, but no
documentary information was provided in response to the request. Mr. Sensenig
did not provide the IRS with any documentary evidence of the interest rate.
The examination continued, and in 2009 Mr. Sensenig agreed with the IRS
that the bad debt deduction was erroneous. Mr. Sensenig said he had been
unaware that the bad debt deduction was claimed on CLCL's 2005 return and
agreed that it should not have been. (Now, however, Mr. Sensenig maintains that
the decision made in 2005 to claim the bad debt deduction was correct because the
events that triggered the loss (chiefly, the cease-and-desist order) occurred in

2005.)
The IRS sent Mr. and Mrs. Sensenig a statutory notice of deficiency

("NOD") on May 13, 2011. For 2005 the NOD disallowed CLCL's bad debt

-15[*15] deduction, attributed the resulting income to the Sensenigs, and determined
the resulting deficiency in tax (along with an accuracy-related penalty under

section 6662(a)).
VIII. Tax Court litigation

After receiving the NOD, the Sensenigs timely filed with the Tax Court in
July 2011 a petition for redetermination of the deficiency, the addition to tax, and
the penalties in the notice. When preparing the petition, Mr. Sensenig concluded
that CLCL should have deducted in 2005 an additional bad debt, arising not from

G-L and LFP but from WSC.
At trial the Court asked Mr. Sensenig to offer into evidence financial
information regarding the companies at issue to show that they could not pay the
debts to CLCL. Mr. Sensenig said the only evidence he could provide was
"common sense evidence". That is, he maintains, because the securities regulators
shut down his investment activity with the June 2005 cease-and-desist order, he
lacked additional funds with which he could keep the companies going, and it was
obvious that the companies were therefore doomed and that CLCL's alleged loans
to them became worthless.

-16[*16] IX.

Ultimate findings of fact

We find that CLCL's advances to G-L, LFP, and WSC were not loans and
that, if they were, they did not become worthless in 2005.

OPINION
The primary issue for decision is whether the Sensenigs are entitled to a
business bad debt deduction for 2005 under section 166(a). The secondary issue is
whether the Sensenigs are liable for the accuracy-related penalty under section

6662(a) for 2005.
I.

Burden of proof
The IRS's determinations are presumed correct; and taxpayers generally

bear the burden to prove their entitlement to any deduction they claim, Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933), and they must satisfy the
specific requirements for any deduction they claim, INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992). To that end, taxpayers must substantiate
each claimed deduction by maintaining records sufficient to establish the amount
of the deduction and to enable the Commissioner to determine the correct tax

liability. Sec. 6001; Higbee v. Commissioner, 116 T.C. 438, 440 (2001).
Specifically, in this case, "[t]he burden of proving the reality of * * * indebtedness

-17[*17] rests on the petitioner." P.M. Fin. Corp. v. Commissioner, 302 F.2d 786,

789 (3d Cir. 1962), § T.C. Memo. 1961-108.
The Court need not accept a taxpayer's self-serving testimony when the
taxpayer fails to present corroborating evidence. Beam v. Commissioner, T.C.

Memo. 1990-304 (citing Tokarski v. Commissioner, 87 T.C. 74, 77 (1986)), ©
without published opinion, 956 F.2d 1166 (9th Cir. 1992).
With respect to an individual taxpayer's liability for penalties and additions
to tax, section 7491(c) places the burden of production on the Commissioner.
II.

Bona fide debt deduction
A.

General principles

A taxpayer is entitled to a deduction for any bona fide debt that becomes
worthless within the taxable year. See sec. 166(a)(1); 26 C.F.R. sec. 1.166-1(c),
Income Tax Regs. To be able to deduct the reported bad debt for 2005, Mr.
Sensenig must show: (1) that the advances made to G-L, LFP, or WSC were debt
(not equity); (2) that the debt became worthless3 in taxable year 2005; and (3) that
3The Sensenigs did not assert entitlement to a deduction for partially
worthless bad debt under section 166(a)(2) in their petition or at trial. The
regulations provide that a partially worthless bad debt may be deducted only to the
extent that the debt is charged off during the taxable year, see 26 C.F.R. sec.
1.166-3(a)(2), Income Tax Regs., but the Sensenigs presented no evidence that
CLCL "charged off" any portion of the purported debt owed by WSC, G-L, or LFP
(continued...)

-18[*18] the debt was incurred not as an investment but in connection with a trade or
business (i.e., the business of promoting, organizing, and financing or selling
corporations). Because we conclude that Mr. Sensenig failed to prove the first and
second of these characteristics, see infra parts II.B and II.C, we need not and do
not reach the third.4
B.

Debt vs. equity

A bona fide debt arises from "a debtor-creditor relationship based on a valid
and enforceable obligation to pay a fixed or determinable sum of money." Kean v.

Commissioner, 91 T.C. 575, 594 (1988); 26 C.F.R. sec. 1.166-1(c), Income Tax
3(...continued)
to CLCL in 2005. For these reasons, and because the Sensenigs failed to prove
that the transfers from CLCL to WSC, G-L, or LFP were loans, we do not further
address section 166(a)(2).

4If CLCL made its advances as an investor and not in the course of a trade
or business, see Whipple v. Commissioner, 373 U.S. 193 (1963), then loans it
made might yield nonbusiness bad debt. Section 166(d) provides that taxpayers
other than corporations may deduct "nonbusiness" bad debts only when they
become worthless and then only as short-term capital losses. See sec. 166(d)(1).
The Commissioner takes the position that section 166(d) limits an individual
taxpayer's deduction of nonbusiness bad debts passed to him through an
S corporation (even though the S corporation is a corporation). See Rev. Rul.
93-36, 1993-1 C.B. 187. For the Sensenigs, a short-term capital loss deduction
would evidently be limited to $3,000. See sec. 1211(b). Because we determine
that CLCL's interests in G-L, LFP, and WSC were not debt and were not
worthless, we need not and do not decide the issue of whether (if they had been
debt) they would have been nonbusiness debt and whether section 166(d) would
apply to limit the deduction.

-19[*19] Regs. By definition, a capital contribution is not a debt for purposes of
section 166. See 26 C.F.R. sec. 1.166-1(c). The question now before us is
whether Mr. Sensenig proved that CLCL's advances to G-L, LFP, and WSC were
loans (giving rise to debts) or instead were equity investments.
1.

Frequent complexities

As we will later show, this case is simpler than some debt-vs.-equity cases,
but to put this case in context, we describe the field generally. Section 385
addresses the classification of whether an interest in a corporation is debt or
equity. The statute authorizes the Secretary to prescribe regulations5 setting forth
factors to be taken into account in resolving the issue, and it provides five factors
that "the regulations may include", sec. 385(b) (emphasis added), the first of
which is "a written unconditional promise to pay on demand or on a specified date
a sum certain in money in return for an adequate consideration in money or
money's worth, and to pay a fixed rate of interest",6 sec. 385(b)(1).
5The Secretary promulgated final regulations under section 385 in October
2016, but those regulations do not apply to the tax years in issue in this case. See
81 Fed. Reg. 72858 (Oct. 21, 2016).
6The other four of the five factors are:
(2) whether there is subordination to or preference over any
indebtedness of the corporation,
(continued...)

-20[*20] In Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968),
the U.S. Court of Appeals for the Third Circuit, to which a decision in this case
will apparently be appealable, enumerated 16 "criteria by which to judge the true
nature of an investment which is in form a debt":
(1) the intent of the parties; (2) the identity between creditors and
shareholders; (3) the extent of participation in management by the
holder of the instrument; (4) the ability of the corporation to obtain
funds from outside sources; (5) the "thinness" of the capital structure
in relation to debt; (6) the risk involved; (7) the formal indicia of the
arrangement; (8) the relative position of the obligees as to other
creditors regarding the payment of interest and principal; (9) the
voting power of the holder of the instrument; (10) the provision of a
fixed rate of interest; (11) a contingency on the obligation to repay;
(12) the source of the interest payments; (13) the presence or absence
of a fixed maturity date; (14) a provision for redemption by the
corporation; (15) a provision for redemption at the option of the
holder; and (16) the timing of the advance with reference to the
organization of the corporation.
IA; see also Scriptomatic, Inc v. United States, 555 F.2d 364, 368 (3d Cir. 1977)
(noting that the weight of precedent in the realm of debt-equity determination
flows from the framework of analysis on the basis of the factors enumerated in Fin
6(...continued)
(3) the ratio of debt to equity of the corporation,
(4) whether there is convertibility into the stock of the corporation,
and
(5) the relationship between holdings of stock in the corporation and
holdings of the interest in question.

Sec. 385(b).

-21[*21] Hay); Trans-Atl. Co. v. Commissioner, 469 F.2d 1189, 1192 (3d Cir. 1972),
afg T.C. Memo. 1970-307; M. W. Wood Enters., Inc. v. United States, 538 F.
Supp. 974, 975 (E.D. Pa. 1982).
However, in such an analysis no single criterion or group of criteria can
"provide a conclusive answer in the kaleidoscopic circumstances which individual
cases present." See Fin Hay Realty Co., 398 F.2d at 697. Moreover, the
enumerated factors should be used only as aids in analyzing the economic reality
of the transaction, that is, whether there is actually a contribution to capital or a
true loan for purposes of a bad debt deduction in income tax computation. R7
The factors outlined in Fin Hay fall roughly into three categories: (1) the
intent of the parties; (2) the form of the instrument; and (3) the objective economic
reality of the transaction as it relates to the risks taken by investors. See Fuscaldo

v. United States, No. 00-CV-2486, 2001 WL 1519684, at *5 (E.D. Pa. Oct. 30,
2001); Fischer v. United States, 441 F. Supp. at 36. We now analyze CLCL's

7See also Scriptomatic Inc. v. United States, 555 F.2d at 367; Joseph
Lupowitz Sons, Inc. v. Commissioner, 497 F.2d 862 (3d Cir. 1974), aff'g in part,
remanding in part T.C. Memo. 1972-238; Trans-Atl. Co. v. Commissioner, 469

F.2d at 1192-1193; Dixie Dairies Corp v. Commissioner, 74 T.C. 476, 493-494
(1980) (finding that due to differing factual circumstances under which debtequity questions arise, where not all the criteria are pertinent, an analysis of a
lesser number will suffice); Fischer v. United States, 441 F. Supp. 32, 36 (E.D. Pa.

1977), affd, 582 F.2d 1274 (3d Cir. 1978).

-22[*22] advances according to those three categories of factors--form, intent, and
economic reality--and we conclude that Mr. Sensenig failed to prove that those
advances were bona fide loans rather than contributions to capital or equity
mvestments.

2.

Analysis
a.

Form

As the foregoing primer illustrates, much debt-vs.-equity controversy
involves ostensible loan instruments that have some characteristics of equity.
Those cases require a comparison of the ostensible loan form of a transaction with
its arguable equity substance. This case, however, is not one that presents "an
investment which is in form a debt", Fin Hay Realty Co., 398 F.2d at 696, but
which may have equity characteristics. Rather, in this case the investment has
little or no form. There is no loan agreement providing for repayment of CLCL's
advances; there is in fact no written agreement of any sort; and Mr. Sensenig never
made any formal demands for repayment.8 (Fin Hay factors 2 and 3.)

8Courts have declined to characterize an advance as a genuine loan when the
transferor fails to take reasonable measures to secure repayment. Geftman v.
Commissioner, 154 F.3d 61, 74 (3d Cir. 1998), rev'g in part, vacating in part T.C.

Memo. 1996-447.

-23[*23] The absence of an unconditional right to demand payment is practically
conclusive that an advance is an equity investment rather than a loan for which an
advancing taxpayer might be entitled to claim a deduction for a bad debt loss.
Sees. 166(a), 385; Fischer v. United States, 441 F. Supp. at 37 (Fin Hay factor 7);

Scriptomatic Inc. v. United States, 397 F. Supp. 753, 759 (E.D. Pa. 1975). Thus,
courts have found the lack of any formality to be inimical to a contention that a
loan exists when there is no provision for interest, no enforceable obligation to
repay the funds advanced, no maturity date, and no provision for superiority.
Fischer, 441 F. Supp. at 37; see also PepsiCo Puerto Rico, Inc. v. Commissioner,
T.C. Memo. 2012-269 (finding that a definite maturity date for payment, without

reservation or condition, is a fundamental characteristic of a debt and that if a
financial instrument does not provide any means to ensure payment of interest, it
is a strong indication of an equity interest).
The salient fact of this case is the lack of written evidence demonstrating
that there was a valid and enforceable obligation to repay on the part of any of the
companies at issue that received advances from Mr. Sensenig through CLCL. (Fin
Flay factor 11.) There is no written evidence of an enforceable obligation between
CLCL and any of the companies at issue, much less a provision for a fixed
maturity date or a fixed rate of interest. (Fin Hay factors 10 and 13.)

-24[*24] Mr. Sensenig is not a financially unsophisticated person unaccustomed to
having written agreements. On the contrary, his arrangements with those who
invested in CLCL's "investor pool" were duly reflected in demand notes that
stated rates of interest, and to those lenders he issued quarterly statements and
Forms 1099 showing the interest that accrued in their favor. The loans allegedly
made by CLCL, however, are undocumented.
Uncorroborated oral testimony is insufficient to satisfy the taxpayer's
burden in an equity-versus-debt determination. See Steiner v. Commissioner, T.C.

Memo. 1981-212, aff'd without published opinion, 688 F.2d 825 (3d Cir. 1982);
Fischer, 441 F. Supp. at 37. The absence of any type of formality typically
associated with loans supports the conclusion that the advances were contributions
to capital.
b.

Intent

At trial Mr. Sensenig testified that "[t]he intent [of] both sides was that this
is a loan and that there would be no profit-sharing. That interest would be paid
and only interest would be paid, and that principal and only principal would be
repaid." There was, he says, an understanding between the parties that "the
borrower will post it as borrowed money and the lender will post it as money

-25[*25] loaned out"; and consistent with that, Mr. Sensenig offered CLCL journal
entries that labeled some advances as loans.
However, for only one of the companies at issue, WSC, did Mr. Sensenig
provide even shareholders' and directors' resolutions authorizing WSC to borrow
from CLCL; and even in that instance, there is no further documentation to

demonstrate that thereafter the authority was actually exercised and a loan was in
fact made to WSC, or that WSC had an obligation to repay such a loan. Instead,
Mr. Sensenig stated that on behalf of CLCL he entered into oral agreements with
G-L, LFP, and WSC to lend money (lines of credit) and that those companies
agreed to borrow the same amounts. But apart from his testimony, there is no
evidence in the record that reflects that CLCL or any of the companies at issue
treated the monetary advances from CLCL as draws on lines of credit, other than
the aforementioned (scattered) journal entries of CLCL.
"[C]onclusory declarations that the parties intended to create debts should
carry little weight." Fischer, 441 F. Supp. at 37; see also Dunmire v.
Commissioner, T.C. Memo. 1981-372. The Court provided Mr. Sensenig with the
opportunity to present evidence to corroborate his testimony, but he was unable to
do so.

-26[*26] "In the absence of direct evidence of intent, the nature of the transaction
may be inferred from its objective characteristics". Geftman v. Commissioner,

154 F.3d 61, 68 (1998), rev'g in part, vacating in part T.C. Memo. 1996447.9 In this case, we meet again the blunt, objective fact that no loans are
documented.
c.

Economic reality

The third category of factors pertains to the economic reality of the
advances. "A court may ascertain the true nature of an asserted loan transaction
by measuring the transaction against the 'economic reality of the marketplace' to
determine whether a third-party lender would extend credit under similar

circumstances." Id. at 76 (quoting Scriptomatic, Inc., 555 F.2d at 367-368).
If an outside lender would not have lent funds to the corporation on the
same terms as did the insider, an inference arises that the advance is not a bona

fide loan. See Fin Hay Realty Co., 398 F.2d at 697; Fischer, 441 F. Supp at 38
("The acid test of the economic reality of a purported debt is whether an unrelated
outside party would have advanced funds under like circumstances").
°Such objective characteristics may include "the presence or absence of debt
instruments, collateral, interest provisions, repayment schedules or deadlines,
book entries recording loan balances or interest payments, actual repayments, and
any other attributes indicative of an enforceable obligation to repay the sums
advanced." Geftman v. Commissioner, 154 F.3d at 68.

-27[*27] Mr. Sensenig stated that the companies he chose to finance were start-up
ventures that could not obtain financing from unrelated banks. (Fin Hay factor 4.)
As a matter of CLCL policy, if a start-up company had other sources or means to
borrow, CLCL would not advance money to it. (And other than the money that
CLCL provided to the companies, no further capital contributions were made by
anyone else.) The three companies at issue were objectively risky debtors, and an
unrelated prospective lender would probably have concluded that they would
likely be unable to repay any proposed loan.
Mr. Sensenig emphasized that, with respect to the advances at issue here, he
generated no formal written financial projections and that he did not know what
those projections would be. He was satisfied to go with the "gut feel of everybody
involved". He considered business plans a waste of time and emphasized the
importance of being able to "turn on a dime" on the basis of the facts of the
moment, unconstrained by any formal plan. We think an unrelated lender would

have considered this approach too cavalier.
When Mr. Sensenig decided to write off the advance to LFP, it was because
he believed the possibility the company would be profitable was remote.¹° And

¹°Specifically for LFP, Mr. Sensenig did not believe any revenue generated
from the patent to polish rebar would be sufficient to repay the debt.

-28[*28] yet CLCL continued to provide financing (of approximately $9 million) to
all three companies after the year 2005 for which the bad debt deduction was
claimed. No prudent lender would have continued to advance money to any of
these companies under such circumstances. Here, the amounts advanced to G-L,
LFP, and WSC were, as a matter of economic reality, placed at the risk of the
businesses and more closely resembled venture capital than loans. (Fin Hay factor
6.) Steiner v. Commissioner, T.C. Memo. 1981-212 (where advances are placed at
the risk of the business, they are typically viewed as contributions to capital rather
than loans).
Since Congress has chosen to give different tax consequences to debt and
equity, it "would do violence to the congressional policy" to treat as debt a
purported loan that "is so risky that it can properly be regarded only as venture
capital." Fischer, 441 F. Supp. at 38 (quoting Gilbert v. Commissioner, 248 F.2d

399, 407 (2d Cir. 1957), remanding T.C. Memo. 1956-137).
To the same effect, an advance may have the economic substance of a loan
where the funds are advanced with a reasonable expectation of repayment
regardless of the success of the venture or are placed at the risk of the business.
Steiner v. Commissioner, T.C. Memo. 1981-212. Mr. Sensenig's expectation of
repayment to CLCL, however, was completely dependent on the future financial

-29[*29] success of the companies (which were not successful). See Scriptomatic,
Im, 397 F. Supp. at 764 (holding advances were not debt where repayment "can
only be reasonably assured by the chance of profits or from the liquidation of the
business"). Repayment of any amount advanced by CLCL to one of the
companies was not anticipated until the project had been "completed". Moreover,
as to WSC, any expectation of repayment was even more remote, given that
CLCL's interest was necessarily subordinate to the interest of WSC's prior
mortgage lender. (Fin Hay factor 8.)
Also at odds with a conclusion that this was a genuine loan transaction is
Mr. Sensenig's not charging any loan origination fees for the advances and his
lack of interest in obtaining third-party audits, financial statements, or credit
reports for the companies he had chosen to invest in.
CLCL's advances simply do not have the appearance of loans. We believe
that no reasonable third-party lender would have extended money to these
companies when none of the objective attributes which denote a bona fide loan are
present, including a written promise of repayment, a repayment schedule, and
security for the loan.
The transfers simply did not give rise to a reasonable expectation or
enforceable obligation of repayment. For these reasons, we find that the

-30[*30] relationship between Mr. Sensenig and CLCL on the one hand and the three
companies on the other was not that of creditor and debtor, and we conclude that
Mr. Sensenig's advances of CLCL funds were in substance equity and that the IRS
properly disallowed the deduction for tax year 2005.
C.

Worthlessness

The Sensenigs' contention of worthless debt fails also because they did not
show the extent to which the supposed debts were indeed worthless in 2005. We
accept that the 2005 cease-and-desist order was a major harmful event for CLCL
and the companies in which it invested; but whether and when that event caused
worthlessness was not demonstrated. Over the time that this controversy has been
pending between the IRS and Mr. Sensenig, he has been inconsistent with regard
to whether claiming the bad debt deduction for 2005 was proper and which
company was the debtor. (Fin Hay factor 1.) The 2005 Form 1120S that Mr.
Sensenig filed for CLCL does not identify the source of the bad debt deduction.
During the IRS's examination, Mr. Sensenig and his accountant, Mr. Smith, stated
that the 2005 bad debt deduction was claimed by CLCL for loans to G-L and LFP.
(This position was consistent with CLCL's general ledger for 2005, on which the
total bad debt included a complete write-off by CLCL of the advances to G-L and

-31[*31] LFP, and yet CLCL continued to advance funds to both companies in
subsequent years.)
However, later in the examination and also in his petition, Mr. Sensenig
conceded the bad debt deduction and explained that he "was in fact surprised that
his bookkeeper had claimed it and admits that he missed the error when signing
the tax return." No other companies were discussed during the examination.
Later in his petition, contradicting himself yet again, Mr. Sensenig included
a handwritten page (which he referred as a "footnote") stating that "the years
following 2005 events have proven that the bad debt as claimed in 2005 was
correct after all and should have been allowed as filed." Mr. Sensenig now
maintains that the bad debt was related to the advances made to WSC and not only
to G-L or LFP; but there is no documentary evidence that CLCL wrote off any
portion of the WSC debts in 2005 on its books; and after the 2005 bad debt
deduction, WSC was still in operation. (Likewise, as of May 2007, G-L and LFP
were still receiving funding from CLCL to pay for business operations.)
Given Mr. Sensenig's shifting position about who owed the supposed bad
debts and whether those debts had become worthless, we cannot give much weight
to his testimony about worthlessness. More important, he put on no evidence as to
the financial condition of the three "borrower" companies as of December 31,

-32[*32] 2005, the end of the remaining year at issue. The Sensenigs did not carry
their burden to prove that any debts were worthless in 2005, and we will sustain
the IRS's disallowance of the bad debt deductions.
III.

Accuracy-related penalty
A taxpayer is liable for an accuracy-related penalty as to any portion of an

underpayment attributable to, among other things, a substantial understatement of
income tax or negligence. Sec. 6662(a) and (b)(1) and (2). There is a substantial
understatement of income tax if the amount of the understatement exceeds the
greater of 10% of the tax required to be shown on the return or $5,000. Sec.

6662(d)(1)(A); 26 C.F.R. sec. 1.6662-4(a), Income Tax Regs.
The Commissioner bears the burden of production with respect to this
penalty. Sec. 7491(c). The IRS's NOD, which made determinations we have
sustained, determined an underpayment due to an understatement of income tax in

excess of both $5,000 and 10% of the total tax required to be shown on
petitioner's 2005 return. And even if the amount of the deficiency is recomputed
under Rule 155, it is clear that the understatement will remain "substantial" for

purposes of section 6662(a)(1)(A). The Commissioner has thus carried his burden
of production by demonstrating a "substantial understatement of income tax."

-33[*33] Once the Commissioner has met the burden of production, the taxpayer
must come forward with persuasive evidence that the penalty is inappropriate
because, for example, he or she acted with reasonable cause and in good faith.
Sec. 6664(c)(1); Higbee v. Commissioner, 116 T.C. at 448-449. The decision as
to whether a taxpayer acted with reasonable cause and in good faith is made on a
case-by-case basis, taking into account all pertinent facts and circumstances. h
26 C.F.R. sec. 1.6664-4(b)(1). Generally, the most important factor is the extent
of the taxpayer's effort to assess her or his proper tax liability. R; see also Shaw

v. Commissioner, T.C. Memo. 2013-170, M, 623 F. App'x 467 (9th Cir. 2015);
Halby v. Commissioner, T.C. Memo. 2009-204. Other circumstances include the
experience, knowledge, and education of the taxpayer, as well as the extent to
which the taxpayer reasonably and in good faith relied on the advice of a
competent professional tax adviser. 26 C.F.R. sec. 1.6664-4(c)(1); see
Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), M, 299

F.3d 221 (3d Cir. 2002).
When asked at trial to provide any argument as to why he should not be held
liable for the penalty, Mr. Sensenig stated: "If I owe the tax, I owe the penalty in
my opinion." We agree. Mr. Sensenig does not rely on a claim of reliance on
advice; rather, he takes full responsibility for the information reported on the

-34[*34] return and does not attribute any fault to his C.P.A. employee who prepared
CLCL's 2005 tax return. Because Mr. Sensenig was a long-time licensed public
accountant and owner of an accounting practice--which at one point prepared over
300 returns per year--his professional experience should have prompted more of
an effort on his part to ensure that his bad debt deduction was proper. His
uncertainty as to which companies' debts warranted the bad debt deduction and his
surprise at learning which companies' debts had been relied on to support the
deduction demonstrate a lack of a diligent effort to ascertain the validity of the tax
deduction.

Under these circumstances, we sustain the IRS's determination of the
accuracy-related penalty.
To reflect the foregoing,

Decision will be entered under
Rule 155.

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Aa1bf87c831ecd5a4. Public record. Not legal advice.