T.C. Memo. 1997-491

UNITED STATES TAX COURT

KENT JENSEN AND CAROL JENSEN, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 20121-94. Filed October 29, 1997.

J. Craig Carman, for petitioners.

Richard W. Kennedy, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

SWIFT, Judge: Respondent determined deficiencies in

petitioners’ joint Federal income taxes, an addition to tax, and

an accuracy-related penalty, as follows: 
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 Accuracy-Related

Addition to Tax Penalty 

Year Deficiency Sec. 6651(a) Sec. 6662(a) 

 

1988 $ 502 -- -- 

1989 4,148 $1,058 -- 

1990 9,335 -- $1,871 

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

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

Procedure. All references to petitioner are to Kent Jensen. 

The issue for decision is whether petitioners are entitled

either to a section 166 business bad debt deduction with respect

to $128,841 that was transferred to petitioners’ closely held

corporation or to a section 1244 ordinary loss deduction in the

same amount with respect to the stock of petitioners’ closely

held corporation.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. 

When the petition was filed, petitioners resided in Centerville,

Utah.

On July 23, 1984, petitioners organized K&C Industries (K&C)

as a corporation to market and sell artificial fingernails. 

Petitioner served as president and treasurer of K&C, and Carol

Jensen served as vice president and secretary of K&C. 

At the time of K&C's formation, petitioners contributed to

K&C $5,882 in cash, office furniture, and a computer system. 
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Petitioners each received 5,000 shares of the common stock of

K&C, representing a 50-percent ownership interest in K&C for each

petitioner. 

From 1984 through 1987, petitioners transferred to K&C an

additional $38,538 in small cash denominations from their

personal funds and $94,000 obtained from petitioner's father.

The following schedule reflects for 1984 through 1987 the

above funds transferred to K&C:

 

 Funds Obtained Funds Obtained From

Year From Petitioners Petitioner’s Father

1984 $11,740 $17,500

1985 22,748 29,000

1986 4,050 44,000

1987 -- 3,500

 Total $38,538 $94,000 $132,538

During 1984, 1985, and 1986, petitioners received from K&C

documents designated as promissory notes in favor of petitioners,

as follows:

Date Of Promissory Note Amount 

 July 23, 1984 $ 7,341

 July 23, 1984 7,341

 Mar. 21, 1985 85,000

 Feb. 12, 1986 30,000 

 Total $129,682

On August 5, 1986, 40,000 shares of K&C stock were issued in

the name of petitioner's father and provided to petitioner’s
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father in connection with the $94,000 that petitioner’s father

had provided for transfer to K&C.

On their 1987 joint Federal income tax return, petitioners

claimed a business bad debt deduction with respect to $128,841

that had been transferred to K&C. After mathematical

modifications required by Schedule A, Form 1045, petitioners

claimed on their 1987 joint Federal income tax return a net

operating loss (NOL) of $127,533 based upon the above $128,841

claimed business bad debt deduction. The claimed net operating

loss of $127,533 was carried forward to petitioners’ joint

Federal income tax returns for 1988, 1989, and 1990. 

Petitioners untimely filed their 1989 joint Federal income

tax return in September of 1991. 

Respondent disallowed petitioners' claimed $128,841 business

bad debt deduction for 1987 and the related $127,533 NOL that

petitioners carried forward to 1988, 1989, and 1990. Respondent

also determined for 1989 an addition to tax with respect to the

late filing of petitioners’ 1989 joint Federal income tax return

under section 6651(a) and for 1990 an accuracy-related penalty

under section 6662(a).

OPINION 

Generally, taxpayers are allowed deductions for bona fide

debts owed to them that become worthless during a year. Sec.

166(a). Bona fide debts generally arise from valid debtor-
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creditor relationships reflecting enforceable and unconditional

obligations to repay fixed sums of money. Sec. 1.166-1(c),

Income Tax Regs. Contributions to the capital of corporations

and other equity investments in corporations do not constitute or

qualify as bona fide debts. Kean v. Commissioner, 91 T.C. 575,

594 (1988).

The question of whether transfers of funds to closely held

corporations constitute debt or equity must be decided on the

basis of all the relevant facts and circumstances, and taxpayers

generally bear the burden of proving that the transfers

constituted loans by the taxpayers to the corporations and not

equity investments. Rule 142(a); Dixie Dairies Corp. v.

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

Various factors are often used to analyze whether funds

transferred to closely held corporations are to be treated as

debt or equity: (1) The treatment of the funds on documents

prepared by the parties to the transaction; (2) the presence or

absence of fixed due dates for repayment of the funds; (3) the

likely source of repayment of the funds; (4) efforts to enforce

repayment of the funds; (5) participation by the transferor of

the funds in management of the corporation; (6) whether the

transferor subordinated right of repayment to the corporation’s

other creditors; (7) the intent of the parties; (8) whether the

transferor of the funds was also a shareholder of the

corporation; (9) the capitalization of the corporation;
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(10) availability to the corporation of outside financing;

(11) use of the funds by the corporation; (12) repayment history;

and (13) the risks involved in making the transfers. Calumet

Indus., Inc. v. Commissioner, 95 T.C. 257, 285 (1990); Dixie

Dairies Corp. v. Commissioner, supra at 493. No single factor is

controlling. Dixie Dairies Corp. v. Commissioner, supra at 493.

Transfers by controlling shareholders to closely held

corporations are subject to heightened scrutiny, and labels

attached to such transfers by controlling shareholders through

bookkeeping entries or testimony have limited significance unless

the labels are supported by objective evidence. Fin Hay Realty

Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968); Dixie

Dairies Corp. v. Commissioner, supra at 495.

Petitioners argue that the $128,841 claimed business bad

debt deduction constituted bona fide business loans by them to

K&C and that the loans became worthless in 1987. Alternatively,

if the funds they transferred to K&C are to be treated as equity,

petitioners argue that a section 1244 ordinary loss deduction

should be allowed with regard thereto.

Respondent argues that the funds petitioners transferred to

K&C should be treated as contributions to the capital of K&C and

that petitioners therefore should not be allowed the claimed

$128,841 business bad debt deduction under section 166. With

regard to the alternatively claimed section 1244 loss, respondent

argues that that section would apply only to the 10,000 shares of
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stock that petitioners owned and not to the 40,000 shares of K&C

stock that were issued in the name of petitioner’s father and

that related to the $94,000 provided by petitioner’s father that

was contributed to K&C. We agree with respondent. 

The evidence in this case undermines the credibility of the

four written promissory notes on which petitioners rely. The

timing and the amount of the four promissory notes do not

correlate with the timing and the amount of the transfers of

funds to K&C. The four promissory notes total $129,682, and the

transfers total $132,538. The testimony regarding the promissory

notes is unclear and inconsistent. 

K&C’s initial capitalization of only $5,882 is grossly

disproportionate to K&C’s purported debt obligations. K&C

appears to have been undercapitalized and unable to obtain

outside financing. 

Petitioners received no repayments of any of the funds

transferred to K&C and no payments of interest thereon.

On the basis of the evidence and considering petitioners’

burden of proof, we find that petitioners have not established

that the $128,841 claimed business bad debt deduction relates to

a bona fide loan. 

 With regard to their alternative claim, petitioners argue

that the 40,000 shares of K&C stock were issued to petitioner’s

father due to a clerical error, that they were the real owners of
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this stock, and that they should be entitled to claim an ordinary

loss with regard thereto under section 1244. 

Generally, we treat facts as they happened, not as they

could or might have happened. See Estate of Legg v.

Commissioner, 40 B.T.A. 1074, 1076 (1939), revd. and remanded on

another issue 114 F.2d 760 (4th Cir. 1940). As respondent

acknowledges, petitioners are entitled to a section 1244 ordinary

loss deduction for the 10,000 shares of stock that were issued to

them. Petitioners, however, have not established their ownership

of the 40,000 shares of K&C stock issued to petitioner’s father,

and petitioners are not entitled to the claimed section 1244

ordinary loss deduction with regard thereto.

In order to avoid the addition to tax for late filing of a

tax return, taxpayers must prove that their failure to file

timely was due to reasonable cause and not to willful neglect. 

Sec. 6651(a); United States v. Boyle, 469 U.S. 241, 245 (1985);

Catalano v. Commissioner, 81 T.C. 8 (1983), affd. without

published opinion sub nom. Knoll v. Commissioner, 735 F.2d 1370

(9th Cir. 1984); sec. 301.6651-1(c)(1), Proced. & Admin. Regs.

Petitioners present no argument to refute the section

6651(a) late filing addition to tax, and respondent’s

determination is sustained. 

Under section 6662(a), a penalty is imposed equal to 20

percent of the portion of the underpayment that is attributable

to a substantial understatement of income tax (namely, an

understatement for a year in excess of 10 percent of the amount

required to be shown on the Federal income tax return or $5,000). 
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Sec. 6662(d)(1). Petitioners present no credible argument as to

the section 6662(a) substantial understatement penalty, and we

sustain respondent’s imposition of this penalty.

To reflect the foregoing, 

Decision will be entered

under Rule 155.