T.C. Memo. 2006-125

UNITED STATES TAX COURT

TIMOTHY J. AND JOAN M. MILLER, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 13635-01. Filed June 15, 2006. 

Brett J. Miller, for petitioners.

Timothy A. Lohrstorfer, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GALE, Judge: Respondent determined the following

deficiencies with respect to petitioners’ Federal income taxes:
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1 All section references are to the Internal Revenue Code

of 1986, as in effect for the years in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

Tax Year Deficiency

1989 $94,685

1991 $23,230

1992 $70,009

1993 $38,083

1994 $23,718

1995 $6,039

After concessions, the issues for decision are:

1. Whether petitioners had sufficient basis under section

1366(d)(1)(B)1 with respect to certain indebtedness incurred to

fund the operations of Miller Medical Systems, Inc. (MMS), an S

corporation in which petitioner Timothy J. Miller was a

shareholder, to entitle them to deduct MMS’s losses of $750,000

in 1992, $431,691 in 1993, and $189,845 in 1994, which led to net

operating loss carryback deductions in 1989, 1990, and 1991, as

well as net operating loss carryover deductions of $238,293 for

1994 and $206,178 for 1995. We hold petitioners had sufficient

basis to deduct the aforementioned losses.

2. Whether petitioners were "at risk" within the meaning of

section 465 with respect to the aforementioned indebtedness at
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2 Joan M. Miller is a petitioner in this case as a result of

filing joint returns with petitioner Timothy J. Miller for the

years in issue. As the transactions at issue involved Mr. Miller

only, we shall hereinafter use "petitioner" when referring to Mr.

Miller individually.

the close of taxable years 1992, 1993, and 1994. We hold that

petitioners were "at risk" for this purpose. 

3(a). Whether petitioners had discharge of indebtedness

income under section 61(a)(12) of $900,000 in 1994, upon the

satisfaction by guarantors of the aforementioned indebtedness to

that extent. We hold that they did.

3(b). Whether the $900,000 of discharge of indebtedness

income is excludable under the insolvency exception of section

108(a)(1)(B). We hold that it is.

3(c). Whether certain tax attributes of petitioners,

including a net operating loss, net operating loss carryover, net

capital loss, and capital loss carryover for 1994 must be reduced

under section 108(b)(1) and (2). We hold that they must.

FINDINGS OF FACT

The parties have stipulated some of the facts, which are

incorporated herein by this reference. Petitioners, Timothy J.

and Joan M. Miller,2 resided in Indiana at the time the petition

was filed. 

MMS’s Initial Years

Petitioner incorporated MMS in November 1988 and was

initially its sole shareholder. MMS was an S corporation for
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3 The parties to the MMS/Huntington Loan executed a loan

agreement, security agreement, and promissory note. Except as

otherwise indicated, reference to the MMS/Huntington Loan

encompasses all three of the foregoing documents.

Federal income tax purposes at all relevant times. MMS was in

the business of manufacturing mobile and modular medical

diagnostic facilities. Shortly after its creation, MMS

established a relationship with Huntington National Bank

(Huntington) to obtain financing for its business activities.

Huntington's loans to MMS were initially on a short-term, "per

project" basis; i.e., funds were lent on the basis of the

contracts MMS obtained for the construction of diagnostic

facilities, to be repaid upon the completion of construction when

MMS was paid.

MMS experienced losses from its inception in 1988 through

1994. In February 1992, petitioner obtained four outside

investors in MMS: George F. Rapp, James D. Rapp, John G. Rapp,

and Gary L. Light (the Rapp Group). The Rapp Group made capital

contributions to MMS of $800,000 in the aggregate in exchange for

approximately 15 percent of MMS’s stock. As a condition for the

Rapp Group's investment, MMS was obligated to secure a commitment

for a $1 million line of credit. MMS did so through Huntington,

which extended a $1 million revolving line of credit to MMS on

March 31, 1992 (the MMS/Huntington Loan3).
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Under the MMS/Huntington Loan line of credit, MMS was

allowed advances of up to $250,000 per modular or mobile

diagnostic unit under contract. Interest at a rate of one-half

point above Huntington's prime rate was payable monthly on the

outstanding principal advanced. MMS executed a promissory note

and granted Huntington a first security interest in MMS's

accounts, inventory, equipment, fixtures, and receivables as

security for the MMS/Huntington Loan. In addition, petitioner

executed an unlimited guaranty for MMS's indebtedness, secured by

a second mortgage on his personal residence, and each member of

the Rapp Group executed limited guaranties which in the aggregate

were equal to the entire $1 million authorized indebtedness. The

Rapp Group guaranties were collateralized with shares of Danek

Group, Inc. (Danek), a publicly traded stock with an aggregate

value that exceeded $1,000,000 when the MMS/Huntington Loan was

executed. 

MMS's annual operating losses accumulated, and petitioner

had insufficient basis in the corporation to deduct them

currently. As of December 31, 1991, petitioner had suspended net

operating loss deductions from MMS as follows:

Suspended net operating loss from 1990 $540,506

Suspended net operating loss from 1991 87,322

Total 627,828
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4 In fact, MMS ultimately reported a 1992 net operating loss

for Federal income tax purposes of $736,237. 

By late 1992, it was apparent that MMS's operations for that year

would also show a loss.4 

The Loan Restructuring

In December 1992, personnel of MMS had discussions with

Huntington concerning the tax benefits of reissuing the line of

credit in the MMS/Huntington Loan to petitioner personally. On

December 17, 1992, petitioner's tax adviser at Ernst & Young sent

a letter to Huntington explaining that petitioner did not have

sufficient basis to deduct his share of MMS’s losses because of

his status as a mere guarantor of the MMS/Huntington Loan. The

letter therefore proposed that the line of credit be reissued to

petitioner personally, with MMS as guarantor, using the same

terms and conditions. Huntington would then lend $750,000 (the

then-outstanding principal balance on the MMS/Huntington Loan) to

petitioner and petitioner would make a $750,000 cash contribution

to MMS, which MMS would use to repay the MMS/Huntington Loan. The

letter concluded by emphasizing that the new credit line would

need to be established before the end of the year to enable

petitioner to deduct his share of MMS's losses for 1992.

In response, Huntington agreed to reissue the line of credit

to petitioner personally with essentially the same terms and

conditions (including the Rapp Group guaranties) as the
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MMS/Huntington Loan, with certain additional conditions. First,

all funds drawn by petitioner on the personal line of credit were

required to be deposited into a restricted account in

petitioner's name at the bank, all withdrawals from the

restricted account were required to go into an account at the

bank maintained by MMS, and petitioner would be required to

warrant that all draws on the personal line of credit would be

used exclusively for MMS's construction costs for diagnostic

units under contract. Second, rather than petitioner’s making

cash contributions to MMS, petitioner would extend a $1 million

line of credit to MMS (to be funded by petitioner's line of

credit with Huntington) for which MMS would execute a promissory

note and security agreement in favor of petitioner. MMS would

provide as security for the line of credit to it from petitioner

the same collateral as had secured MMS's original line of credit

from Huntington. Finally, rather than have MMS serve as

guarantor with respect to the line of credit extended by

Huntington to petitioner, petitioner would instead make a

collateral assignment to Huntington of all of petitioner's rights

under the security agreement given to petitioner by MMS for the

line of credit running between them, as well as a collateral

assignment of the promissory note executed by MMS in favor of

petitioner.
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5 Unless otherwise indicated, reference to the

Miller/Huntington Loan encompasses all three of these documents.

6 Unless otherwise indicated, reference to the MMS/Miller

Loan encompasses all three of these documents.

The restructuring of the line of credit was undertaken on

December 30, 1992. On that date, Huntington extended a $1

million revolving line of credit to petitioner personally (the

Miller/Huntington Loan) on a full recourse basis. To evidence

the indebtedness, petitioner personally executed a loan

agreement, security agreement, and full recourse promissory note

in favor of Huntington.5 On the same day, petitioner extended a

$1 million revolving line of credit to MMS (the MMS/Miller Loan). 

To evidence the indebtedness, MMS executed a loan agreement,

security agreement, and promissory note in favor of petitioner.6

Petitioner drew down $750,000 of his credit line under the

Miller/Huntington Loan, lent it to MMS pursuant to the MMS/Miller

Loan, and MMS in turn used the proceeds to pay the outstanding

balance of the MMS/Huntington Loan. On its records, Huntington

recorded the MMS/Huntington Loan as satisfied in full by virtue

of a $750,000 principal payment on December 30, 1992. 

Both the Miller/Huntington and MMS/Miller Loans were due on

December 31, 1993, and carried the same interest rate as the

MMS/Huntington Loan (one-half point above Huntington's prime

rate), with interest payable monthly and advance payments of

principal permitted. The Miller/Huntington and MMS/Miller Loans
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contained the same limitation on advances as in the

MMS/Huntington Loan; namely, advances could be made from

Huntington to petitioner, and from petitioner to MMS, only with

respect to a maximum of $250,000 to cover MMS's construction

costs for diagnostic facilities under contract. Pursuant to the

conditions imposed by Huntington in agreeing to restructure the

line of credit, the advances to petitioner under the

Miller/Huntington Loan were deposited into a restricted account

in petitioner's name for transfer to MMS. Similarly, when MMS

made a payment with respect to its obligation to petitioner under

the MMS/Miller Loan, such payment was required to be deposited by

petitioner into a restricted account and held in trust for

Huntington.

As security for the MMS/Miller Loan, MMS granted petitioner

a security interest in the same collateral that had secured the

MMS/Huntington Loan; namely, all of its assets, including

equipment, inventory, accounts receivable, etc. In the security

agreement for the Miller/Huntington Loan, petitioner made a

collateral assignment to Huntington of all of his rights under

the MMS/Miller Loan, including the promissory note executed in

his favor by MMS. With respect to the promissory note, the

Miller/Huntington Loan security agreement provided as follows:

Timothy J. Miller ("Debtor") * * * hereby grants,

pledges and assigns to The Huntington National Bank of
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Indiana ("Bank"), a security interest in the following

property * * * :

* * * * * * *

(b) All of Debtor's rights in, to, and

under a certain Commercial Loan

Note executed by Miller Medical

Systems, Inc. on or about December

30, 1992 [i.e., the MMS/Miller

promissory note];

* * * * * * *

The security interest hereby granted is to secure

the prompt and full payment and complete performance of

all Obligations of Debtor to Bank.

The foregoing security interest in MMS's promissory note was also

described in the loan agreement for the Miller/Huntington Loan as

follows:

As security for the Loan, * * * [petitioner] shall

make a collateral assignment of all * * *

[petitioner's] rights and interests arising under or in

connection with the * * * [MMS/Miller Loan], including

but not limited to, * * * a pledge of any and all

promissory notes executed by * * * [MMS] in favor of *

* * [petitioner] * * * .

Huntington filed a Uniform Commercial Code financing statement on

December 31, 1992, to perfect a security interest in the property

petitioner had collaterally assigned to it pursuant to the

Miller/Huntington Loan, including the "Commercial Loan Note

executed by Miller Medical Systems, Inc. on or about December 30,

1992". 
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7 Specifically, the guaranty agreement executed by each Rapp

Group member provided as follows:

In order to induce the Bank [Huntington] to lend money

or advance credit to, renew, extend or forbear from

demanding immediate payment of the Obligations of

Debtor [petitioner], in reliance, in part, upon this

Guaranty, GUARANTOR HEREBY WAIVES * * * ANY RIGHT OF

INDEMNITY, REIMBURSEMENT OR CONTRIBUTION FROM THE

DEBTOR * * * and the Guarantor further waives any right

of subrogation to the rights of the Bank against the

Debtor * * * which would otherwise arise by virtue of

any payment made by the Guarantor to the Bank on

account of this Guaranty, * * * and the Guarantor

undertakes on behalf of himself, his legal

representatives and assigns that neither the Guarantor

nor the Guarantor's legal representatives or assigns

will attempt to exercise of [sic] accept the benefits

of any such right and should the Guarantor * * *

receive any payment * * * on account of such right

notwithstanding the provisions of this paragraph, such

money * * * shall be held in trust by the recipient for

(continued...)

Petitioner also granted Huntington a second mortgage in his

personal residence as security for his obligations under the

Miller/Huntington Loan.

As with the MMS/Huntington Loan, the Rapp Group members

provided limited guaranties with respect to the Miller/Huntington

Loan that in the aggregate covered its $1 million principal,

collateralized with the same Danek stock, which at the time had a

value exceeding $2,500,000. In their respective guaranty

agreements, each member of the Rapp Group also waived any rights

of indemnification, subrogation, reimbursement, or contribution

from petitioner with respect to the Miller/Huntington Loan (the

guarantor waivers).7
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7(...continued)

the Bank * * * . 

Petitioner agreed to certain covenants with respect to the

Miller/Huntington Loan, including covenants that, other than the

extension of credit by petitioner to MMS under the MMS/Miller

Loan line of credit, petitioner would not, and would cause MMS

not to, lend or incur indebtedness (except indebtedness for the

purchase of property equal to the purchase price). Petitioner

was also required under the Miller/Huntington Loan to submit

MMS's financial statements and a report of MMS's accounts

receivable to Huntington on a monthly basis, and to submit his

personal financial statements as Huntington might from time to

time require. No covenants had been required of petitioner as

guarantor of the MMS/Huntington Loan. The Miller/Huntington Loan

further provided that an event of default would exist if either

petitioner or MMS became insolvent, or if MMS failed to comply

with any provision of the MMS/Miller Loan. 

On its Federal income tax return and financial statement for

the 1992 calendar year, MMS reported a $750,000 loan from a

shareholder as of yearend.

Modifications to the Restructured Loan

On February 15, 1993, the lines of credit under the

Miller/Huntington Loan and MMS/Miller Loan were both increased by

$250,000. These changes were effected through loan modification
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agreements executed by petitioner and Huntington, and MMS and

petitioner, respectively. Petitioner executed a $250,000

promissory note in favor of Huntington, and MMS executed a

$250,000 promissory note in favor of petitioner, to cover the

increased amounts under the respective credit lines. Likewise,

each member of the Rapp Group executed limited guaranties that in

the aggregate covered the increase in the Miller/Huntington line

of credit to $1,250,000. Other than the $250,000 increase, the

terms and conditions of the foregoing loan agreements and

guaranties did not change in any material respect. 

Huntington's internal report covering the $250,000 increase

listed the primary source of repayment as "Personal cash flow [of

petitioner] and/or funds from Miller Medical Systems, Inc." 

The Miller/Huntington Loan line of credit was drawn down to

its full $1,250,000 authorized amount by November 1, 1993. 

Required monthly payments of interest were made to Huntington,

along with periodic principal payments and draws, so that the

outstanding balance on the Miller/Huntington Loan was $1,184,930

as of yearend 1993. On its Federal income tax return for 1993,

MMS reported $1,184,930 in loans from shareholders as of yearend,

essentially the same figure recorded by Huntington as the
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8 Huntington's records list the 1993 yearend balance as

$1,185,000, whereas the parties have stipulated that the figure

was $1,184,930. The $70 discrepancy is not material, in our

view.

outstanding balance on the Miller/Huntington Loan as of that

date.8

On January 19, 1994, the line of credit under the

Miller/Huntington Loan was increased an additional $250,000 to

$1,500,000. Petitioner executed a new promissory note in favor

of Huntington for $1,500,000, which covered this increase and

served as a substitute for the previously executed $1 million and

$250,000 promissory notes. The line of credit under the

MMS/Miller Loan was similarly increased, and MMS also executed a

new promissory note in favor of petitioner for $1,500,000 which

replaced the two prior outstanding promissory notes between the

two. Parallel modifications were made to the limited guaranties

of the Rapp Group, so that the guaranties in the aggregate

covered the entire $1,500,000 amount authorized under the

Miller/Huntington Loan. Huntington's internal report on the

increase of the Miller/Huntington Loan to $1,500,000 listed the

primary source of repayment as "Personal cash flow [of

petitioner] and/or funds from Miller Medical Systems, Inc." 

Additional security was provided in connection with the

increase in the Miller/Huntington Loan to $1,500,000. First,

petitioner's parents granted Huntington a $50,000 second mortgage
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9 The $70 discrepancy between the stipulated 1994 yearend

balance of the Miller/Huntington Loan and the figure reported by

MMS as the outstanding amount of loans from shareholders is not

material, in our view. Cf. supra note 8. 

on their personal residence as additional security for the

Miller/Huntington Loan. Second, the loan agreement for the

Miller/Huntington Loan was amended to require that the market

value of the collateral securing the loan be maintained in

amounts at least one-third greater than the authorized credit

line; if not, Huntington could require Miller or the Rapp Group

to provide additional security.

The newly increased Miller/Huntington Loan line of credit

was drawn down to its full $1,500,000 authorized amount by April

8, 1994. Required monthly payments of interest were made to

Huntington, along with periodic principal payments and draws, so

that the outstanding balance on the Miller/Huntington Loan was

$1,375,000 as of December 28, 1994. On its Federal income tax

return for 1994, MMS reported $1,374,930 in loans from

shareholders as of yearend.9

On June 30, 1994, the security provided for the

Miller/Huntington Loan was again modified. The loan agreement

was amended to require the Rapp Group to pledge collateral in the

form of public securities (rather than Danek stock) with

aggregate base and call values of $2,009,450.94 and of

$1,785,385.42, respectively.
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10 It was anticipated that the completion of MMS's

outstanding contracts, coupled with the liquidation of its

assets, would result in proceeds of approximately $475,000.

MMS's Default

In December 1994, MMS became insolvent. At that time, there

was an outstanding balance of $1,375,000 on the Miller/Huntington

Loan. On December 29, 1994, the Rapp Group, as guarantors, paid

$900,000 to Huntington in partial satisfaction of the

Miller/Huntington Loan. The Rapp Group then satisfied the

remaining $475,000 on the Miller/Huntington Loan by taking out

personal loans from Huntington and using the proceeds to purchase

the Miller/Huntington Loan note.10 Concurrently, petitioner and

the Rapp Group formed a new entity operating under the name MSR

Technologies, LLC (MSR), which purchased MMS's remaining assets

and completed MMS's outstanding contracts. Upon MSR's completion

of the contracts, MSR paid the proceeds to the Rapp Group, which

in turn used the proceeds to repay their personal loans from

Huntington. 

As of the trial in this case, petitioner had not made any

payments to the Rapp Group to reimburse them for their payments to

satisfy the Miller/Huntington Loan pursuant to their guaranties,

nor had the Rapp Group sought reimbursement from petitioner. 

Petitioner submitted a personal financial statement as of

December 29, 1994, to Huntington in connection with MMS's default,

which listed assets of $583,000 (consisting of petitioner's
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11 Although petitioner listed the outstanding balance for

the Miller/Huntington Loan as $1,500,000 on the financial

statement, it is undisputed that the balance was $1,375,000.

12 A Jan. 17, 1995, report by MMS to its creditors disclosed

that, as of yearend 1994, MMS's secured debt substantially

exceeded its assets, and that the company had an additional

$1,800,000 of unsecured debt. 

residence, bank account, automobile, and personal property), and

liabilities of $310,000 (consisting of a mortgage on petitioner's

residence, an automobile loan, and other accounts payable). 

Petitioner listed the Miller/Huntington Loan as a contingent

liability, thereby excluding it as a liability for purposes of

calculating his net worth.11 Excluding the Miller/Huntington Loan,

petitioner's net worth as of December 29, 1994, was listed as

$273,000 ($583,000 in assets minus $310,000 in liabilities). 

Petitioner did not list his MMS stock as an asset on the financial

statement because MMS had ceased operations and was insolvent.12

Petitioners' Return Positions

Reflecting the outstanding balances on the Miller/Huntington

Loan and the MMS/Miller Loan at the end of 1992, 1993, and 1994 of

$750,000, $1,184,930, and $1,375,000, respectively, petitioners

claimed basis in indebtedness from MMS of $750,000 as of December

31, 1992, as well as annual increases of $434,930 as of December

31, 1993, and $190,000 as of December 31, 1994. Petitioners

consequently deducted ordinary corporate losses from MMS in the

amount of $750,000 for 1992, $431,691 for 1993, and $189,845 for
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13 The amount of interest that MMS may have deducted on its

Forms 1120S, U.S. Income Tax Return for an S Corporation, for

1993 and 1994 with respect to the Huntington loans is not

disclosed in the record. Huntington's records indicate that the

bank received $58,067.97 and $108,522.81 in interest payments

with respect to the Miller/Huntington Loan in 1993 and 1994,

respectively.

1994. These deductions produced net operating loss carryback

deductions of $485,303 for 1989, $87,174 for 1990, and $83,018 for

1991, as well as net operating loss carryover deductions of

$238,293 for 1994 and $206,178 for 1995. 

Petitioners in addition claimed a net short-term capital loss

of $5,849 and a long-term capital loss carryover of $8,194 for

1994, both of which were subsequently carried over into 1995. 

 Petitioners did not report any interest income incident to

the MMS/Miller Loan on their 1993 return. On their 1994 return,

petitioners reported $109,674 of taxable interest income

attributable to MMS.13

Respondent's Determinations

In a notice of deficiency, respondent determined that

petitioners were not entitled to any basis in the Huntington

indebtedness in 1992, 1993, or 1994 and disallowed petitioners'

claimed losses of $750,000, $431,691, and $189,845, in 1992, 1993,

and 1994, respectively, as well as the resulting net operating

loss carryback deductions of $485,303 for 1989, $87,174 for 1990,

and $83,018 for 1991, and carryover deductions of $238,293 for

1994 and $206,178 for 1995. Respondent also determined that
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14 Respondent now contends that only $900,000 of the Dec.

29, 1994, payment by the guarantors constitutes cancellation of

indebtedness income to petitioners.

petitioners were not "at risk" as of the close of 1992, 1993, and

1994, with respect to the amounts borrowed from Huntington, and

disallowed the deductions on that basis. Furthermore, respondent

determined in the alternative that if any of the foregoing

deductions from MMS were allowed, then the payment by guarantors

of $1,350,000 in 1994 was "taxable forgiveness of debt income" to

petitioners.14

OPINION

Issue 1. Section 1366(d)(1)(B) Basis Limitation

Section 1366(a) provides that a shareholder of an S

corporation shall take into account his pro rata share of the S

corporation's items of income, loss, deduction, or credit. 

However, a shareholder may deduct his share of the S corporation’s

losses only to the extent of his adjusted basis in his stock of

the S corporation, sec. 1366(d)(1)(A), and "the shareholder’s

adjusted basis of any indebtedness of the S corporation to the

shareholder", sec. 1366(d)(1)(B) (emphasis added). Any S

corporation losses so limited may be carried forward indefinitely. 

Sec. 1366(d)(2).

The jurisprudence in this area has fleshed out certain

principles relating to the limitation set forth in section

1366(d)(1)(B) and the situations under which a shareholder
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15 The economic outlay requirement stems from the concept

that an S corporation shareholder should be entitled to basis to

the extent of his investment in the S corporation. S. Rept.

1983, 85th Cong., 2d Sess. 219-220 (1958), 1958-3 C.B. 922, 1141

("The amount of the net operating loss apportioned to any

shareholder * * * is limited under [former] section 1374(c)(2)

[the predecessor of sec. 1366(d)] to the adjusted basis of the

shareholder’s investment in the corporation; that is, to the

adjusted basis of the stock in the corporation owned by the

shareholder and the adjusted basis of any indebtedness of the

corporation to the shareholder." (emphasis added)); see also

Perry v. Commissioner, 54 T.C. 1293, 1296 (1970) (concluding that

the word "investment" indicated an intent to limit a

shareholder’s basis to that shareholder’s "actual economic

outlay").

16 As we noted in Perry, the "poorer in a material sense"

standard for testing an economic outlay merely restates the wellsettled predicate for allowing any deduction. Perry v.

Commissioner, supra at 1296. 

acquires basis with respect to indebtedness. See Hitchins v.

Commissioner, 103 T.C. 711, 715 (1994); Grojean v. Commissioner,

T.C. Memo. 1999-425, affd. 248 F.3d 572 (7th Cir. 2001). First, a

shareholder must make an actual economic outlay. Underwood v.

Commissioner, 535 F.2d 309 (5th Cir. 1976), affg. 63 T.C. 468

(1975); Perry v. Commissioner, 54 T.C. 1293, 1296 (1970), affd. 27

AFTR 2d 71-1464, 71-2 USTC par. 9502 (8th Cir. 1971).15 The

economic outlay must leave the taxpayer "poorer in a material

sense" in order for its bona fides to be respected. Perry v.

Commissioner, supra at 1296; see also Bergman v. United States,

174 F.3d 928, 933 (8th Cir. 1999).16

Next, the S corporation's indebtedness must run directly to

the shareholder; an indebtedness to a passthrough entity that
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advanced the funds and is closely related to the taxpayer does not

satisfy the statutory requirements. Frankel v. Commissioner, 61

T.C. 343 (1973), affd. without published opinion 506 F.2d 1051 (3d

Cir. 1974); Burnstein v. Commissioner, T.C. Memo. 1984-74. 

Furthermore,

No form of indirect borrowing, be it a guaranty, surety,

accommodation, comaking or otherwise, gives rise to

indebtedness from the corporation to the shareholders

until and unless the shareholders pay part or all of the

existing obligation. Prior to that crucial act,

“liability” may exist, but not debt to the shareholders. 

[Raynor v. Commissioner, 50 T.C. 762, 770-771 (1968).] 

Basis-generating "direct" indebtedness of the S corporation

to the shareholder for purposes of section 1366(d)(1)(B) generally

arises when a shareholder makes a loan to his S corporation. That

a shareholder may fund his loan to the S corporation with money

borrowed from a third-party lender does not alter the tax

consequences. Bolding v. Commissioner, 117 F.3d 270 (5th Cir.

1997), revg. T.C. Memo. 1995-326; Underwood v. Commissioner, supra

at 312 n.2; Hitchins v. Commissioner, supra at 718 & n.8; Raynor

v. Commissioner, supra at 771. However, where the source of the

funding for such "back-to-back" loans is a related party instead

of an independent third-party lender, this and other courts have

often found that a shareholder made no economic outlay sufficient

to create basis since the necessity of the shareholder's repayment

of the funds is uncertain, see, e.g., Oren v. Commissioner, 357

F.3d 854 (8th Cir. 2004), affg. T.C. Memo. 2002-172; Underwood v.
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17 Rev. Rul. 75-144, 1975-1 C.B. 277, held that basis is

generated on the shareholder’s substitution of his note for the S

corporation's note if the corporation becomes indebted to the

shareholder under State law subrogation rules. In Gilday v.

Commissioner, T.C. Memo. 1982-242, however, we dispensed with the

subrogation requirement and held that where a shareholder

substituted his own note for the S corporation’s and the

corporation’s debt was extinguished, the corporation became

indebted to the shareholder, regardless of the effect of State

law subrogation rules, and thus the shareholder was entitled to

basis in the substituted note under the predecessor of sec.

1366(d)(1)(B). 

Commissioner, supra, although not invariably, see Yates v.

Commissioner, T.C. Memo. 2001-280; Culnen v. Commissioner, T.C.

Memo. 2000-139, revd. on another ground 28 Fed. Appx. 116 (3d Cir.

2002). Thus, the presence of a third-party lender as a source of

the funds lent by the shareholder to his S corporation has been an

important factor in determining whether the shareholder made an

actual economic outlay. The certainty that an unrelated, arm'slength lender will enforce repayment from the shareholder supports

the conclusion that the shareholder has made an economic outlay in

connection with lending funds to his S corporation. See Oren v.

Commissioner, supra; Bergman v. United States, supra.

The same result as a "back to back" loan is reached where a

shareholder substitutes his own note for the note of his S

corporation on which he was a guarantor, thereby becoming the sole

obligor on the new indebtedness. Gilday v. Commissioner, T.C.

Memo. 1982-242; see also Rev. Rul. 75-144, 1975-1 C.B. 277.17 In

such "note substitution" scenarios, so long as the S corporation's
- 23 -

18 In Gilday, the S corporation did not execute promissory

notes in favor of the shareholders until sometime after the year

in issue.

indebtedness to the third-party lender is extinguished, so that

the shareholder becomes the sole obligor to the lender, the

shareholder's assumption of what was formerly the S corporation's

legal burden serves as a constructive furnishing of funds to the S

corporation for which the S corporation becomes indebted to repay

to the shareholder. See Hitchins v. Commissioner, 103 T.C. at

718; Gilday v. Commissioner, supra; Rev. Rul. 75-144, supra. 

Viewing the restructuring of the line of credit as a whole,

we believe that under the principles of Gilday v. Commissioner,

supra, and Raynor v. Commissioner, supra, petitioners are entitled

to the basis they have claimed. The December 30, 1992,

transaction conformed in all material respects to the note

substitution in Gilday. Petitioner gave his fully recourse $1

million promissory note to Huntington to replace MMS's promissory

note of like amount on which he had formerly served as guarantor. 

Huntington thereupon advanced $750,000 under petitioner's note and

recorded MMS's note as satisfied by virtue of the payment of its

$750,000 outstanding balance. MMS in turn gave a promissory note

to petitioner which mirrored the terms of petitioner's note to

Huntington.18 Participating in the foregoing transactions was an

independent, third-party lender, a factor "critical to the result

in Gilday". Bergman v. United States, supra at 933; see also Oren
- 24 -

19 Petitioners argue in addition that the restructuring of

the line of credit also enabled Huntington to remove the

indebtedness from its internal "watch list". However, we find

that the bank officer's testimony on this point is too uncertain,

and the claim itself too improbable, to persuade us that the

substitution of petitioner (who lacked substantial net worth) for

MMS as the primary obligor to Huntington caused the loan to be

removed from the watch list. A much more plausible explanation

for the removal from the watch list, in our view, was the

addition of the fully collateralized guaranties of the Rapp

Group, which covered the full amount of the outstanding

indebtedness.

v. Commissioner, T.C. Memo. 2002-172. As in Gilday, a principal

motivation for the note substitution was to generate basis for

purposes of section 1366(d)(1)(B).19

Similarly, the two subsequent $250,000 increases in the

respective credit lines extended by Huntington to petitioner and

by petitioner to MMS on February 15, 1993, and January 19, 1994,

followed the format of back-to-back loans that were held to create

basis in Raynor v. Commissioner, supra. See also Bolding v.

Commissioner, supra; Yates v. Commissioner, supra; Culnen v.

Commissioner, supra. That is, petitioner borrowed the additional

amounts from Huntington and immediately re-lent them to MMS, with

the indebtedness between petitioner and Huntington, and between

MMS and petitioner, fully documented. 

Therefore, petitioner made an economic outlay, which left him

poorer in a material sense, by virtue of becoming the fully

recourse obligor on enforceable debt held by an independent,
- 25 -

20 In addition, the restrictive covenants imposed on

petitioner in connection with the Miller/Huntington Loan

significantly constrained his ability to lend and borrow money.

third-party lender.20 Petitioner then re-lent the proceeds of this

indebtedness to MMS, creating direct indebtedness of his S

corporation to him, within the meaning of section 1366(d)(1)(B),

in sufficient amounts to cover the losses claimed in 1992, 1993,

and 1994.

Respondent contends, however, that no substantive

indebtedness was created between petitioner and Huntington as a

result of the restructuring because MMS remained in substance the

borrower from Huntington. In respondent's view, petitioner was at

best some kind of accommodation surety with respect to the

indebtedness, a role insufficient to give him basis under section

1366(d)(1)(B). In support of this position, respondent makes

various arguments, including a claim that Huntington still held a

promissory note from MMS after the restructuring; that petitioner

was required by Huntington to assign to Huntington the promissory

note given to him by MMS in connection with the MMS/Miller Loan,

as well as all other MMS assets that had previously secured the

MMS/Huntington Loan; that the proceeds of the Miller/Huntington

indebtedness were required to be used by MMS and MMS was the

source of repayment; and that petitioner did not consistently

report interest income from the MMS/Miller Loan. Thus, in

respondent's view, petitioner's status as borrower from Huntington
- 26 -

21 Respondent's apparent goal is to draw a parallel with

Hitchins v. Commissioner, 103 T.C. 711, 717-718 (1994), wherein

the lack of a cancellation or novation of the original debt

between the taxpayer and his C corporation, which debt was

assumed by the taxpayer's S corporation, figured prominently in

our conclusion that the S corporation's assumption of that debt

did not create direct indebtedness between it and the taxpayer

for purposes of the predecessor of sec. 1366(d)(1)(B). 

and lender to MMS should be disregarded, and the transaction

treated as in substance still a loan from Huntington to MMS, with

the result that petitioners obtained no basis for purposes of

section 1366(d)(1)(B).

We find respondent's arguments unpersuasive. Respondent's

assertion at various points that Huntington still held MMS's

promissory note21 is not supported by the record. Concededly, 

petitioners did not produce a canceled version of the

MMS/Huntington promissory note, but Huntington's business records

document the note as satisfied on December 30, 1992, by payment of

its $750,000 balance. 

Respondent further contends that MMS, not petitioner, was in

substance the borrower from Huntington because petitioner was

required by Huntington to assign to Huntington the MMS/Miller

promissory note. Because of the assignment, Huntington

"essentially owned and controlled" the note MMS executed in favor

of petitioner and was its "beneficial owner", respondent argues. 

By contrast, petitioners maintain that petitioner made only a

collateral assignment of the note. We agree with petitioners. 
- 27 -

Under Indiana law,

[a]n assignment is a transfer which confers a complete

and present right in a subject matter to the assignee. 

* * * In determining whether an assignment has been

made, the question is one of intent. * * * A written

agreement assigning a subject matter must manifest the

assignor's intent to transfer the subject matter clearly

and unconditionally to the assignee. * * * [Brown v.

Ind. Natl. Bank, 476 N.E.2d 888, 894 (Ind. Ct. App.

1985); citations omitted.]

By contrast, "an agreement which conditionally transfers ownership

rights to a creditor and permits the creditor to exercise its

right only upon a default is a security agreement--not an outright

assignment." Smoker v. Hill & Associates, 204 Bankr. 966, 973

(N.D. Ind. 1997) (emphasis added) (citing Brown v. Ind. Natl.

Bank, supra at 892). 

The terms of Huntington's interest in the MMS/Miller

promissory note are delineated in the security agreement executed

by petitioner under the Miller/Huntington Loan, which states:

Timothy J. Miller ("Debtor") * * * hereby grants,

pledges and assigns to The Huntington National Bank of

Indiana ("Bank"), a security interest in the following

property * * * :

* * * * * * *

(b) All of Debtor's rights in, to, and

under a certain Commercial Loan Note

executed by Miller Medical Systems,

Inc. on or about December 30, 1992

[i.e., the MMS/Miller promissory

note];

* * * * * * *
- 28 -

22 In a similar vein, we find no material significance in

the fact that petitioner was required to make a collateral

(continued...)

The security interest hereby granted is to secure

the prompt and full payment and complete performance of

all Obligations of Debtor to Bank. [Emphasis added.]

Given the foregoing terms of the security agreement,

respondent's contention that petitioner made an outright

assignment to Huntington of the MMS/Miller promissory note must

fail. The security agreement clearly sets forth a collateral

assignment of a security interest in the note. Moreover, a

Uniform Commercial Code financing statement was filed on December

31, 1992, to perfect Huntington's security interest in the

"Commercial Loan Note executed by Miller Medical Systems, Inc. on

or about December 30, 1992". Thus, respondent's repeated

contention that "at any given point in time, Huntington held

promissory notes for the identical amount due it from both Mr.

Miller and MMS" is simply wrong; it is inconsistent with the

rights and obligations effected in the restructuring. After the

restructuring, MMS would become directly liable to Huntington only

in the event of a default by petitioner or MMS. Absent default,

MMS was directly liable to petitioner, not Huntington. 

Consequently, petitioner's collateral assignment of the MMS/Miller

promissory note to Huntington provides no grounds for disregarding

the separate indebtedness running between MMS and petitioner, and

between petitioner and Huntington.22
- 29 -

22(...continued)

assignment to Huntington of all the other MMS assets pledged to

him as security for the MMS/Miller Loan (which assets had

previously secured the MMS/Huntington Loan). The taxpayer in

Bolding v. Commissioner, 117 F.3d 270 (5th Cir. 1997), revg. T.C.

Memo. 1995-326, was treated as the true borrower notwithstanding

that the assets acquired by his S corporation with the loan

proceeds were pledged as security for the taxpayer's loan. 

Respondent in addition points out that MMS was the recipient

of the loan proceeds and the expected source of repayment, citing

authorities where these factors contributed to a finding that no

basis was generated by the indebtedness. While these factors have

been cited by courts, it has generally been in situations where

the taxpayer and his S corporation were co-obligors on the 

indebtedness, or the taxpayer was claiming basis notwithstanding

his status as a mere guarantor or surety. See, e.g., Estate of

Leavitt v. Commissioner, 90 T.C. 206 (1988), affd. 875 F.2d 420

(4th Cir. 1989); Borg v. Commissioner, 50 T.C. 257 (1968); Salem

v. Commissioner, T.C. Memo. 1998-63, affd. 196 F.3d 1260 (11th

Cir. 1999); Reser v. Commissioner, T.C. Memo. 1995-572, affd. in

part and revd. in part on another ground 112 F.3d 1258 (5th Cir.

1997). In any event, the use of the loan proceeds by the

corporation is far from dispositive; the loan proceeds were

intended for and used by the corporations in the back-to-back loan

and note substitution arrangements in Raynor v. Commissioner, 50

T.C. 762 (1968), and Gilday v. Commissioner, T.C. Memo. 1982-242,

cases where the indebtedness was held to generate basis. As for
- 30 -

the expected source of repayment, Huntington's contemporaneous

records indicate that it was looking both to petitioner and to MMS

for repayment. Huntington's internal reports prepared in

connection with the bank's decisions to increase the authorized

principal of the Miller/Huntington Loan in February 1993 and

January 1994 both listed the primary source of repayment as

"Personal cash flow [of petitioner] and/or funds from Miller

Medical Systems, Inc." Moreover, when the authorized principal

amount of the Miller/Huntington Loan was increased for the second

time in January 1994, Huntington sought and obtained a second

mortgage on the residence of petitioner's parents, suggesting that

Huntington continued to rely on petitioner personally as a source

of repayment. In short, the use of proceeds and source of

repayment factors do not persuade us that the loan from Huntington

to petitioner should be disregarded, and MMS treated as borrowing

directly from Huntington rather than petitioner.

We also attach little consequence to petitioners'

inconsistent tax reporting of the interest arising from the 

Miller/Huntington and MMS/Miller Loans. Petitioners failed to

report any interest income from the MMS/Miller Loan in 1993, but

they reported $109,674 of such interest in 1994. Since the

MMS/Miller Loan and Miller/Huntington Loan had mirror terms for

interest, any interest income petitioner received on the

MMS/Miller Loan would have been offset by petitioner's interest
- 31 -

23 As part of his adjustments in the notice of deficiency,

respondent eliminated the $109,674 of interest reported as income

by petitioners for 1994 but appears to suggest on brief that

petitioners must recognize this income. We disagree, because it

would appear that petitioners' interest income from the

MMS/Miller Loan is offset by their interest expense on the

Miller/Huntington Loan. We expect the parties to resolve any

discrepancies in accounting for interest expense in their Rule

155 computations.

expense on the Miller/Huntington Loan, presumably resulting in a

wash.23 On its 1992, 1993, and 1994 returns, MMS consistently

reported the outstanding yearend balance of the restructured

financing as loans from shareholders.

Respondent also relies on Grojean v. Commissioner, T.C. Memo.

1999-425, affd. 248 F.3d 572 (7th Cir. 2001), to support his

position that petitioner, after the loan restructuring, was in

substance merely an accommodation surety or guarantor of a loan

made by Huntington to MMS. In Grojean v. Commissioner, supra, the

taxpayer acquired a participation interest in a third-party bank's

loan to his S corporation, using funds lent to him by the bank for

this purpose. We rejected the taxpayer's claim that his

participation interest in the loan resulted in indebtedness of his

S corporation to him for purposes of section 1366(d)(1)(B). We

held instead that, under the principle of Gregory v. Helvering,

293 U.S. 465, 469-470 (1935), that a transaction's substance

controls over its form, the arrangement was in substance a mere

guaranty by the taxpayer of the indebtedness, which did not give

rise to basis.
- 32 -

In finding that the arrangement in Grojean v. Commissioner,

supra, was in substance a mere guaranty by the taxpayer, we

emphasized several factors. First, there was no debtor-creditor

relationship between the S corporation and the taxpayer. The

taxpayer was not a party to the note between the bank and the S

corporation; he had no direct rights against the S corporation,

and the S corporation had no direct obligation to him. Instead,

the taxpayer's only contractual relationship was with the bank,

and the bank had sole discretion to enforce all rights against the

S corporation under the indebtedness. Second, the participation

agreement creating the taxpayer's participation interest provided

that the bank's interest in the S corporation's note was superior

to the participation interest. The taxpayer received interest and

principal only after the bank received its share of these items. 

Third, the S corporation's certified financial statements

reflected the taxpayer's lack of creditor status, as they reported

his participation interest as a guaranty of the corporation's

indebtedness. Finally, because the bank had lent the taxpayer the

funds with which to acquire the participation interest, and the S

corporation's repayment obligation mirrored the taxpayer's

repayment obligation for the acquisition funds, the taxpayer

"would not be out-of-pocket unless and until * * * [the S

corporation] failed to make payments under the * * * note" to the

bank. Thus, we concluded, the taxpayer was in substance a
- 33 -

guarantor of the indebtedness between the S corporation and the

bank.

In applying the "substance over form" doctrine in Grojean v.

Commissioner, supra, we did not purport to overrule Raynor v.

Commissioner, supra, or Gilday v. Commissioner, supra. Instead,

we emphasized the distinctions between the lending arrangement in

Grojean and those found to give rise to basis in Raynor and

Gilday. We reasoned that, in Raynor, the taxpayer had borrowed

from a third party and then directly lent the funds to his S

corporation, whereas the taxpayer in Grojean "did not relend the

funds directly to" his S corporation. Grojean v. Commissioner,

supra. In Gilday, we observed, the taxpayer (along with other

shareholders of an S corporation) issued his note to a third-party

bank which thereupon canceled the S corporation's note it held. 

In exchange, the S corporation gave its note of the same amount to

the taxpayer (and other shareholders). The result, we noted, was

direct indebtedness of the S corporation to the shareholders in

Gilday, whereas the S corporation in Grojean "was not directly

indebted to petitioner in any way, and petitioner's rights were

against * * * [the bank], not * * * [the S corporation]." Grojean

v. Commissioner, supra. 

When the loan arrangements at issue are compared to those in

Grojean v. Commissioner, supra, on the one hand and to those in

Raynor v. Commissioner, supra, and Gilday v. Commissioner, supra,
- 34 -

24 MMS's financial statements for 1993 and 1994 are not in

the record.

on the other, the present arrangements fall outside our holding in

Grojean. Upon completion of the loan restructuring, MMS's

original indebtedness to Huntington (the MMS/Huntington Loan) was

recorded by the bank as satisfied, and petitioner held MMS's note

(and related security agreement) under which MMS was directly

indebted to petitioner and petitioner had direct, unsubordinated

rights as creditor against MMS. Under the principles of Gilday,

petitioner's substitution of his note for MMS's note with

Huntington constituted a constructive furnishing of funds to MMS

by petitioner, giving rise to direct indebtedness. On MMS's

financial statement and tax return for 1992, and its tax returns

for 1993 and 1994,24 the restructured indebtedness was reported as

a loan from a shareholder, not a shareholder guaranty. Pursuant

to the later modifications to the loan agreements, under which

additional amounts were advanced to MMS, petitioner obtained funds

from Huntington in exchange for his note, which were then provided

to MMS in exchange for MMS's note to petitioner, in conformance

with the back-to-back loan transactions that gave rise to basis in

Raynor.

The Court of Appeals for the Seventh Circuit, to which an

appeal in this case lies, affirmed our decision in Grojean,

applying substance-over-form principles. Grojean v. Commissioner,
- 35 -

25 In one of the subsequent modifications increasing the

outstanding principal on the Miller/Huntington Loan, Huntington

(continued...)

248 F.3d 572 (7th Cir. 2001). Nothing in the Court of Appeals

opinion dictates a decision in respondent's favor. See Golsen v.

Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir.

1971). In affirming our holding that the taxpayer was a guarantor

rather than a lender of funds for his S corporation, the Court of

Appeals offered an analysis of the difference between a lender and

a guarantor: while both assume a risk of default, a lender

procures or supplies funds for a borrower whereas a guarantor (by

assuming the risk of default) enables funds to be supplied to the

borrower. Grojean v. Commissioner, 248 F.3d at 573. In

concluding that the taxpayer was a guarantor rather than lender,

the Court of Appeals observed:

Grojean [the taxpayer] did not procure $1.2 million for

the use of Schanno [the S corporation], as he would have

done had he gone to a bank or other lender, borrowed

$1.2 million from it, and written a check for that

amount to Schanno. [Id.] 

The Court of Appeals also affirmed our conclusion (which it

construed as an alternate holding) that there was no basisgenerating direct indebtedness between the taxpayer and his S

corporation because no debtor-creditor or other contractual

relationship existed between them. Id. at 576.

Here, petitioner borrowed from Huntington--on a fully

recourse basis,25 accepting restrictive covenants to obtain the
- 36 -

25(...continued)

also obtained a second mortgage on petitioner's parents'

residence as security for the indebtedness.

funds--and re-lent the funds to MMS in exchange for MMS's note and

related security agreement, creating a direct debtor-creditor

relationship between petitioner and MMS. Thus, petitioner

"procured" funds for MMS, making him a lender rather than a

guarantor under the Court of Appeals analysis, and petitioner had

direct rights against MMS as a creditor, distinguishing this

arrangement from the participation interest at issue in Grojean.

In sum, we conclude that the restructuring transaction,

wherein petitioner borrowed from Huntington on a recourse basis

and re-lent to MMS, with both loans fully documented so as to

create enforceable legal obligations, contains "adequate

substance" so that it is "not to be disregarded." Hitchins v.

Commissioner, 103 T.C. at 719. After the restructuring, MMS was

directly indebted to petitioner, and petitioner had enforceable

creditor's rights against MMS. Consequently, there was

indebtedness "of" MMS "to" petitioner within the meaning of

section 1366(d)(1)(B), so that the outstanding indebtedness under

the MMS/Miller Loan at the close of 1992, 1993, and 1994 generated

basis in those amounts.

Issue 2. "At Risk" Limitation

Respondent argues, in the alternative, that in the event it

is concluded that petitioners had sufficient basis to deduct the
- 37 -

26 The determination of the amount that a taxpayer has "at

risk" as to a given activity is made at the close of the taxable

year. Sec. 465(a)(1).

claimed losses for the years in issue, the deductions are not

allowable because petitioners were not "at risk" within the

meaning of section 465 with respect to the Huntington

indebtedness. 

 Section 465(a) limits the losses a taxpayer may deduct with

respect to a particular activity to the "aggregate amount with

respect to which the taxpayer is at risk * * * for such activity".

Sec. 465(a); Alexander v. Commissioner, 95 T.C. 467, 469 (1990),

affd. without published opinion sub nom. Stell v. Commissioner,

999 F.2d 544 (9th Cir. 1993). Section 465(c)(3)(A)(i) provides

that the "at risk" rules apply to each activity engaged in by the

taxpayer in carrying on a trade or business or for the production

of income.

A taxpayer's "at risk" amount includes the amount of money

and the adjusted basis of other property contributed by the

taxpayer to the activity, section 465(b)(1)(A), as well as certain

amounts borrowed with respect to the activity.26 Sec.

465(b)(1)(B). For borrowed amounts relating to a particular

activity, a taxpayer is considered to be "at risk" where the

taxpayer is personally liable for repayment of such amounts or has

pledged assets unrelated to the business for which the money was

borrowed. Sec. 465(b)(2)(A) and (B); Krause v. Commissioner, 92
- 38 -

27 By comparison, the Court of Appeals for the Sixth Circuit

employs a "worst-case scenario" standard in analyzing whether a

transaction runs afoul of sec. 465(b)(4). See, e.g., Pledger v.

United States, 236 F.3d 315, 319 (6th Cir. 2000). Although the

Court of Appeals for the Seventh Circuit, to which this case is

appealable, has not expressly adopted either standard, we note

that it has cited the "realistic possibility of loss" standard

with approval. See HGA Cinema Trust v. Commissioner, 950 F.2d

1357, 1362-1363 (7th Cir. 1991), affg. T.C. Memo. 1989-370. 

T.C. 1003, 1016-1017 (1989), affd. sub nom. Hildebrand v.

Commissioner, 28 F.3d 1024 (10th Cir. 1994). However, a taxpayer

will not be considered "at risk" with respect to borrowed amounts

if the amounts are protected against loss "through nonrecourse

financing, guarantees, stop loss agreements, or other similar

arrangements." Sec. 465(b)(4); see also Oren v. Commissioner, 357

F.3d at 859.

In analyzing whether a particular transaction runs afoul of

section 465(b)(4), the standard we have generally employed is

whether the taxpayer faces any "realistic possibility of economic

loss" on the transaction. Levien v. Commissioner, 103 T.C. 120,

126 (1994), affd. without published opinion 77 F.3d 497 (11th Cir.

1996).27 Stated differently, where a transaction is structured so

as to remove any realistic possibility of the taxpayer suffering

an economic loss, the taxpayer is not "at risk" for the borrowed

amounts. Id.; see also Oren v. Commissioner, supra. 

Respondent argues that petitioners were not "at risk" with

respect to the Huntington indebtedness because the guarantor

waivers executed by the Rapp Group resulted in petitioners’ being
- 39 -

28 Absent a waiver, a guarantor generally is entitled to

recover from the primary obligor any amounts that the guarantor

is required to pay to satisfy indebtedness. See, e.g., Brand v.

Commissioner, 81 T.C. 821, 828 (1983).

"protected against loss" within the meaning of section 465(b)(4). 

In respondent's view, because the Rapp Group waived any right of

recovery from petitioner in the event that they were required to

perform under their guaranties,28 petitioners faced no realistic

possibility of loss with respect to the amounts borrowed from

Huntington and, therefore, may not deduct losses attributable

thereto. As part of his argument, respondent maintains that

petitioner was a third-party beneficiary of the contract embodied

in the guarantor waivers, and could therefore have defeated any

action by the Rapp Group to recover from him the amounts they paid

to Huntington under their guaranties.

Even assuming arguendo that the Rapp Group was effectively

precluded from obtaining any reimbursement from petitioner of

their guaranty payments, we do not agree that this factor

eliminated any realistic possibility of loss by petitioner with

respect to the Miller/Huntington Loan. Under the

Miller/Huntington Loan, petitioner was the primary obligor on a

recourse basis. He gave a second mortgage on his residence to

secure his obligation. It is true that when MMS declared

insolvency (which was an event of default under the

Miller/Huntington Loan), Huntington in fact sought and obtained
- 40 -

recovery from the Rapp Group guarantors, presumably because at

that time petitioner's net worth, disregarding the

Miller/Huntington Loan, was $273,000, consisting primarily of

relatively illiquid assets such as the equity in his residence, an

automobile, and items of personal property. However, had

petitioner's financial circumstances been different, Huntington

was entitled to seek full or partial recovery from him and quite

possibly would have done so. In short, there was no certainty

that the guarantors would be called upon to satisfy the

indebtedness. As a consequence, we conclude that petitioner had a

realistic possibility of loss thereon.

Respondent relies on Levien v. Commissioner, supra, and Oren

v. Commissioner, supra, in support of his contention that

petitioners were protected from loss within the meaning of section

465(b)(4). In those cases, we concluded that the offsetting

obligations of all the parties to an arrangement would cease in

the event of nonpayment by one party, resulting in no loss to the

taxpayer. However, the transactions at issue in those cases bear

no meaningful resemblance to the indebtedness under scrutiny in

this case. Here, depending on the circumstances, petitioner could

have been required to satisfy all or part of the Miller/Huntington

Loan, even if MMS ceased making payments to him under the

MMS/Miller Loan. We accordingly conclude that petitioners were at

risk within the meaning of section 465 with respect to the amounts
- 41 -

29 Although the determination in the notice of deficiency

was apparently predicated on the assumption that the outstanding

principal of the Miller/Huntington Loan was approximately

$1,350,000 when the Rapp Group assumed responsibility for it, the

actual figure was $1,375,000. The discrepancy need not concern

us, however, as respondent has now conceded that only $900,000 of

the indebtedness was satisfied by the Rapp Group in 1994.

borrowed from Huntington; that section does not preclude

petitioners' entitlement to the losses claimed. 

Consequently, we hold that petitioners' at-risk amounts with

respect to their investment in MMS encompass the full amount of

the outstanding balances on the Miller/Huntington Loan at the end

of 1992, 1993, and 1994; namely, $750,000, $1,184,930, and

$1,375,000, respectively.

Issue 3. Discharge of Indebtedness

A. Section 61(a) Inclusion

Respondent determined, in the alternative, that in the event

deductions for the 1992, 1993, and 1994 losses were allowed, then

petitioners must recognize $1,350,000 as discharge of indebtedness

income in 1994 (i.e., the amount that the examining agent

determined was the outstanding balance due on the

Miller/Huntington Loan that was paid off or assumed by the Rapp

Group on December 29, 1994).29 Respondent now concedes that the

Rapp Group repaid only $900,000 of the Miller/Huntington Loan in
- 42 -

30 On brief, respondent also asserts as an alternative

argument that petitioners must recognize the income under the

principles of Old Colony Trust Co. v. Commissioner, 279 U.S. 716

(1929), because petitioner's obligation to repay Huntington was

discharged by a third party; namely, the Rapp Group. Respondent

also cites sec. 1.61-14(a), Income Tax Regs., to support the

alternative determination of income. However, the determination

in the notice of deficiency, maintained in the answer, was that

petitioners were required to recognize "forgiveness of debt"

income. Respondent has not sought to amend the pleadings to

assert any theory beyond forgiveness of indebtedness income, and

we decline to allow him to do so for the first time on brief.

See, e.g., Smalley v. Commissioner, 116 T.C. 450, 456 (2001).

1994, and consequently only $900,000 is includible in petitioners'

1994 income under respondent's alternative determination.30 

Section 61(a) states that, unless otherwise provided: "gross

income means all income from whatever source derived". Included

within this broad definition is income from the discharge of

indebtedness, which occurs when a taxpayer is released from his

indebtedness or the indebtedness is satisfied for less than its

face amount. Sec. 61(a)(12); United States v. Kirby Lumber Co.,

284 U.S. 1 (1931); Cozzi v. Commissioner, 88 T.C. 435, 445 (1987). 

The theory underlying discharge of indebtedness income is that

loan proceeds previously untaxed because offset by a repayment

obligation are freed up when the obligation is eliminated without

payment, resulting in an accession to income. United States v.

Kirby Lumber Co., supra at 3. Whether a debt has been discharged

is dependent on the substance of the transaction. Cozzi v.

Commissioner, supra. 
- 43 -

Respondent contends that petitioners received $900,000 of

discharge of indebtedness income on December 29, 1994, when the

Rapp Group paid that amount as guarantors in partial satisfaction

of the Miller/Huntington Loan. Petitioner was at this point

released from his obligation to the extent of $900,000, respondent

argues, because the Rapp Group had waived any right to

reimbursement from petitioner under the guarantor waivers. 

Petitioners contend that no discharge occurred on December 29,

1994, because petitioner remained liable to the Rapp Group for the

$900,000 they paid as guarantors. 

We agree with respondent. The only evidence supporting the

contention that petitioner remained liable to the Rapp Group for

$900,000 is his self-serving testimony to that effect. We are not

required to accept such testimony. See Tokarski v. Commissioner,

87 T.C. 74, 77 (1986). Balanced against petitioner's testimony

are, first, the terms of the guarantor waivers, under which the

Rapp Group waived any right of indemnification or reimbursement

(or subrogation from Huntington) against petitioner that would

otherwise arise by virtue of any payment under their guaranties. 

Second, in the more than 8 years between the Rapp Group's payment

under their guaranties and the trial in this case, the Rapp Group

did not seek reimbursement from petitioner, nor did petitioner

make any payment in satisfaction of his purported liability to

them.
- 44 -

A debt is deemed discharged as soon as it becomes clear, on

the basis of a practical assessment of all the facts and

circumstances, that it will never have to be repaid. Cozzi v.

Commissioner, supra at 445. The existence of a faint possibility

that a debt will be collected does not prevent the recognition of

discharge of indebtedness income. Exch. Sec. Bank v. United

States, 492 F.2d 1096, 1099 (5th Cir. 1974). Moreover,

petitioners bear the burden to prove that the event determined by

respondent as effecting the discharge is unreasonable. Cozzi v.

Commissioner, supra at 447-448. Based on the foregoing principles

and circumstances, we conclude that petitioners had discharge of

indebtedness income of $900,000 on December 29, 1994, when the

Miller/Huntington Loan was satisfied to that extent by the Rapp

Group's payments pursuant to their guaranties.

 B. Section 108(a)(1)(B) Exclusion

Petitioners further contend that if they had $900,000 of

discharge of indebtedness income in 1994, then they are entitled

to exclude it under section 108(a)(1)(B) because petitioner was

insolvent within the meaning of that section when the discharge

occurred. Section 108(a)(1)(B) provides that "Gross income does

not include any amount which * * * would be includible in gross

income by reason of the discharge (in whole or in part) of

indebtedness of the taxpayer if * * * the discharge occurs when

the taxpayer is insolvent". The exclusion afforded by section
- 45 -

31 The Dec. 29, 1994, financial statement does not attribute

any value to petitioner's MMS stock as of that date. In our

view, that characterization is accurate, as an MMS notice to its

creditors, dated Jan. 17, 1995, disclosed that MMS’s secured debt

exceeded the value of its assets, and its unsecured debts

exceeded $1,800,000. Accordingly, we are persuaded that the MMS

stock was worthless as of Dec. 29, 1994.

108(a)(1)(B) is limited to the amount by which the taxpayer is

insolvent. Sec. 108(a)(3). A taxpayer is insolvent for these

purposes when his liabilities exceed the fair market value of his

assets, as determined immediately before the discharge. Sec.

108(d)(3).

A financial statement of petitioner, prepared as of December

29, 1994, listed total assets of $583,00031 and total liabilities

of $310,000, resulting in a net worth of $273,000. However, the

Miller/Huntington Loan was not included in the foregoing

liabilities; instead, it was listed as a "contingent liability" of

$1,500,000. That amount was apparently an estimate, as the

parties have stipulated that the outstanding balance on the

indebtedness to Huntington was $1,375,000 as of December 29, 1994.

Petitioners argue that the characterization of the

Miller/Huntington Loan as a contingent liability on the financial

statement was an error, and that it should have been counted as a

liability for purposes of determining petitioner's solvency as of

December 29, 1994. If the $1,375,000 outstanding balance of the

Miller/Huntington Loan were so treated, petitioner's net worth as
- 46 -

of December 29, 1994, would be ($1,102,000); namely, $583,000 in

assets minus $1,685,000 in liabilities.

Respondent, relying on Merkel v. Commissioner, 109 T.C. 463

(1997), affd. 192 F.3d 844 (9th Cir. 1999), argues that petitioner

was solvent as of December 29, 1994, because the $1,375,000

balance of the Miller/Huntington Loan was a contingent liability

that, given the Rapp Group guaranties and the guarantor waivers,

was unlikely to be paid by petitioner. Thus, respondent contends,

the balance owed on the Miller/Huntington Loan should not be

counted in determining whether petitioner was insolvent for

purposes of section 108(a)(1)(B).

We believe respondent misreads Merkel. The contingent

liabilities at issue in Merkel were not the same indebtedness that

was being discharged, as is largely the case here. To suggest as

respondent does that the discharged debt, because it is being

discharged, does not count as a liability for purposes of

determining insolvency under section 108(a)(1)(B) contravenes the

statute's design and purpose. Section 108(d)(3) provides that the

determination of whether a taxpayer is insolvent is to be made on

the basis of the taxpayer's assets and liabilities "immediately

before the discharge." The quoted language evidences an intent to

count those liabilities for which discharge is imminent. If one

argues, as respondent does, that the discharge of the

Miller/Huntington Loan gives rise to discharge of indebtedness
- 47 -

32 We recognize that the foregoing analysis applies

principally to the $900,000 portion of the Miller/Huntington Loan

that respondent contends was discharged for purposes of sec.

61(a)(12) in 1994. However, petitioner's liability under the

remaining $475,000 portion of the Miller/Huntington Loan, which

was purchased by the Rapp Group on Dec. 29, 1994, satisfies the

standard set forth in Merkel v. Commissioner, 109 T.C. 463, 484

(1997), for recognizing a liability for purposes of the

insolvency exception, because it was more probable than not,

immediately before the discharge, that petitioner would be called

upon to pay that obligation in the stated amount.

We reach this conclusion based on the following: (i) The

Rapp Group purchased $475,000 of the Miller/Huntington Loan

(thereby becoming petitioner's creditors rather than guarantors)

because it was anticipated that the completion of MMS's

outstanding contracts, plus the liquidation of its assets, would

result in proceeds of approximately this amount; (ii) petitioner

formed a new entity with the Rapp Group, to which MMS's assets

and outstanding contracts were transferred, for the purpose of

completing MMS's contracts; and (iii) the $475,000 portion of the

indebtedness was in fact subsequently satisfied with such

contract proceeds and asset liquidation.

income for petitioner, because the discharge effects a freeing of

assets previously offset by the liability arising from that loan,

then it necessarily follows that petitioner's liability on the

Miller/Huntington debt was not contingent and is to be treated as

in existence immediately before the discharge.32

We therefore agree with petitioners that the $1,375,000

balance on the Miller/Huntington Loan as of December 29, 1994,

should be counted as a liability in determining whether petitioner

was insolvent when the discharge occurred, which results in

insolvency on that date to the extent of $1,102,000.

As the amount of petitioner's insolvency exceeds $900,000, the

entire amount of the discharge of indebtedness income is excluded
- 48 -

33 Petitioners had income from other sources in 1994 that

partially offset the $189,845 loss they claimed for that year

from their investment in MMS.

34 The reduction in petitioners' tax attributes for 1994

noted above results in correlative adjustments to petitioners'

1995 tax attributes; namely, the elimination of the $206,178 net

operating loss carryover, $5,849 short-term capital loss

carryover, and $8,194 long-term capital loss carryover claimed by

petitioners for 1995.

from petitioners' gross income under section 108(a)(1)(B). See

sec. 108(a)(3).

C. Tax Attribute Reduction

Any amount excluded under section 108(a)(1)(B) must be

applied to reduce certain tax attributes of the taxpayer,

including, inter alia, any net operating loss or net capital loss

for the taxable year of the discharge and any net operating loss

carryover or any capital loss carryover to such taxable year. 

Sec. 108(b)(1) and (2)(A), (D). Respondent contends that in the

event we determine that petitioners are entitled to exclude any

discharge of indebtedness income, then petitioners must eliminate

their claimed tax attributes as follows: A net operating loss of

$163,47533 for 1994; a net operating loss carryover to 1994 of

$238,293; a net short-term capital loss of $5,849 for 1994; and a

long-term capital loss carryover to 1994 of $8,194.34 We agree and

so hold. 

 
- 49 -

Conclusion

 We have carefully considered all remaining arguments made by

the parties for contrary holdings and, to the extent not

discussed, find them to be irrelevant, moot, or without merit. 

 To reflect the foregoing, 

Decision will be entered

under Rule 155.