T.C. Memo. 1997-83

UNITED STATES TAX COURT

ALTON W. BURNS AND PAMELA BURNS, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21995-94. Filed February 19, 1997.

Peter Ambelang, for petitioners.

Susan E. Seabrook, for respondent.

MEMORANDUM OPINION

PAJAK, Special Trial Judge: This case was heard pursuant to

section 7443A(b)(3) of the Code and Rules 180, 181, and 182. All

section references are to the Internal Revenue Code in effect for

the year in issue. All Rule references are to the Tax Court

Rules of Practice and Procedure.
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Respondent determined a deficiency in petitioners' 1989

Federal income tax in the amount of $5,434, and an accuracyrelated penalty under section 6662(a) in the amount of $689. 

After concessions by both parties, the Court must decide whether

petitioners are entitled to a short-term capital loss carryover

deduction for the year in issue.

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

For clarity and convenience, our findings of fact and opinion

have been combined. Petitioners resided in Mayer, Arizona, when

their petition was filed.

On their 1989 Federal income tax return, petitioners claimed

a short-term capital loss carryover deduction of $139,384. This

carryover originated from a nonbusiness bad debt deduction of

$205,029 petitioners claimed on the Schedule D attached to their

1985 Federal income tax return. Resolution of the 1989

deficiency depends upon the validity of the claimed bad debt

deduction in a prior year. Sec. 6214(b).

On their 1985 return, Schedule D, petitioners originally

claimed that the $205,029 nonbusiness bad debt deduction was for

J. Riviera Boats, Inc (Riviera). Riviera was a business entity

formerly owned and operated by petitioners. Petitioners now

allege that the $205,029 bad debt deduction stems not just from

Riviera, but also from Arizona Marine, another business entity

formerly owned and operated by petitioners.
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Riviera manufactured fiberglass boats. Petitioners

incorporated Riviera on January 12, 1978. Petitioners were the

100-percent shareholders of Riviera. Petitioner husband was the

president of Riviera, and petitioner wife was its vice president.

Petitioners initially invested $30,000 for the common stock

of Riviera. Petitioners also initially "loaned" Riviera

$42,809.03 represented by a promissory note. In return for

advancing these funds, Riviera executed a 6-page security

agreement on January 13, 1978, that granted petitioners, among

other rights, a security interest in "all boats, motors, pumps,

inventory, molds, equipment, tools, raw materials, work in

process and accounts receivable".

By August 31, 1979, petitioners claim they had advanced

Riviera an additional $44,755.81. Riviera and petitioners

executed a total of $87,564.84 in promissory notes as of that

date.

On October 9, 1979, in a document entitled "Action by

Unanimous Written Consent of the Board of Directors", Riviera

ratified the above-mentioned "borrowings" described in the

security agreement and the promissory notes. On October 9, 1979,

petitioners, in their individual capacities, sent a letter to

Riviera demanding "payment of the total amounts due [$87,564.84]

under the notes including interest not later than 10 days from

receipt of this letter."
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By a letter dated October 22, 1979, Riviera informed

petitioners that:

Due to a downturn in the economy, Riviera Boats of

Arizona, Inc. is unable at this time to repay the loans

evidenced by the promissory notes referred to in your

letter of October 9, 1979.

Although Riviera Boats fully intended to repay the

amounts borrowed, an unfortunate series of events in

the last months now makes it impossible to do so at

this time. * * *

Petitioner husband signed this letter as president of Riviera.

By a letter dated October 24, 1979, petitioners informed

Riviera that "Under the circumstances, we will have to assert our

rights to take possession of the collateral that secured

repayment of our loans to Riviera Boats." In a subsequent letter

dated October 31, 1979, petitioners informed Riviera:

We have assessed the value of the collateral and have

decided to retain the collateral in satisfaction of the

obligations owed by Riviera Boats of Arizona, Inc. to

us. This letter shall constitute written notice of our

proposal to retain the collateral in satisfaction of

the debts owed us by Riviera Boats.

Petitioners did not introduce evidence of the specific

property they received from Riviera in the October 1979

transaction. Petitioner husband testified generally that the

collateral consisted of "[boat] molds, the inventory and all the

equipment." Petitioner husband believed the value of the boat

molds was equal to the value of the notes to Riviera. He also

testified that the replacement cost of the molds was "probably

two to $300,000 if you were buying what somebody else made. 

Because we made them, our labor was cheap. So basically all we
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had was materials in the molds." Petitioners did not have the

assets, including the boat molds, appraised or valued at the time

of the exchange. However, on Riviera's Form 1120, U.S.

Corporation Income Tax Return, for the year ending September 30,

1980, Riviera's assets were valued at $135,731.

Petitioners claim that Riviera was liquidated on October 31,

1979, the date they retained the collateral. The parties have

stipulated that Riviera conducted no business from approximately

September 30, 1980 to September 30, 1990. However, Federal

corporate income tax returns continued to be filed for Riviera up

until the year ending September 30, 1990. For the years ending

September 30, 1980, September 30, 1981, September 30, 1982,

September 30, 1983, and September 30, 1984, Riviera continued to

claim depreciation deductions for office equipment on the

corporate tax returns. Petitioner husband claimed the corporate

tax returns continued to be filed for the following reason:

We didn't file in each year, Your Honor. My attention

was -- as we were shut down and that was the end of it,

and then we didn't file any income tax returns after we

shut down.

And then IRS wrote us a letter, so we went ahead

and the accountant took the last return and filed it

and sent them in. And at that time we thought maybe

things could turn around and we could maybe start back

up, which never happened. Things were improving, but

it still didn't work out that way.

Riviera's Federal corporate income tax return for the year

ending September 30, 1980, reflects the sum of $78,541 as

shareholder loans from petitioners to Riviera, and $30,000 as
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petitioners' Common Stock Investment. As mentioned, the

promissory notes from Riviera to petitioners indicate $87,564.84

of loans from petitioners to Riviera as of August 31, 1979. 

Petitioner husband could not explain this discrepancy. 

Petitioners have no records of amounts Riviera may have repaid to

petitioners.

The second business entity petitioners allege to be related

to their $205,029 bad debt deduction is Arizona Marine. Arizona

Marine was engaged in the repair and sale of recreational boats.

In November 1977, petitioners sold Arizona Marine to Mr. and Mrs.

Richard Reed. The Purchase and Sale Agreement executed by

petitioners and the Reeds provided that the Reeds purchased "all

of the fixtures and equipment, inventory, goodwill, customer

lists and relationships, leasehold rights", as well as all rights

to the names "Arizona Marine", "Arizona Marine Boat and Motor

Sales and Service", and "Arizona Marine Water Sports Center". 

The Purchase and Sale Agreement did not specifically assign a

dollar value to each of these assets. Rather, the agreement

refers to these assets collectively as the "Business Assets", and

states that the purchase price for the Business Assets is

$202,110.

As part of the purchase, the Reeds executed a promissory

note, payable to petitioners, in the amount of $133,866. 

Petitioner husband testified petitioners realized roughly a

$30,000 profit on this sale. Petitioner husband also testified
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petitioners reported the gain from this sale under the

installment method. Petitioners did not introduce into evidence

a copy of their 1977 Federal income tax return.

In 1979, the Reeds sold their interest in Arizona Marine to

Mr. and Mrs. Lee Lieberman. Petitioners agreed to the release of

the Reeds from their obligations, and the substitution of the

Liebermans. The Liebermans executed a promissory note dated

October 1, 1979, in the amount of $117,464.48, payable to

petitioners. The Liebermans also granted petitioners a security

interest in certain inventory and equipment of Arizona Marine. 

The record does not disclose how petitioners treated this

transaction on their 1979 Federal income tax return.

In 1980, the Liebermans defaulted under the promissory note

and petitioners filed an action for injunction and forcible entry

and detainer against Arizona Marine in the Superior Court of the

State of Arizona, Maricopa County. At the time of default, the

balance due on the promissory note was $112,334.25. The action

was settled under the terms of a settlement agreement and an

agreement relating to petitioners' lessor's lien and security

interest in certain Arizona Marine property. The settlement

agreement, entered into on May 9, 1980, provides:

3. [Arizona Marine] agrees to, contemporaneously

with the surrender of the premises to Burns, also

surrender to Burns the following:

(a) All of its inventory which consists of

goods, merchandise and other personal property

owned by [Arizona Marine] in connection with its
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marine sales and service business but expressly

does not include any boats, new outboard or

inboard motors, new outdrive units or boat

trailers.

(b) All of the equipment used and owned by

[Arizona Marine] in connection with its marine

sales and service business, including but not

limited to furnishings, fixtures, leasehold

improvements, tools and other personal property.

* * * [Arizona Marine] makes no representation of value

or amount of inventory or equipment and Burns expressly

agrees to accept whatever is present at the premises at

the date and time set forth in paragraph 1. * * *

* * * * * * *

5. Burns acknowledges complete satisfaction of

all remaining obligations due Alton W. and Pamela A.

Burns under the Promissory Note * * *.

The agreement relating to petitioners' lessor's lien and

security interest in certain Arizona Marine property, also

entered into on May 9, 1980, provides:

[I]n consideration of payment from [Mr. Lieberman] to

BURNS in the sum of Twenty Thousand Dollars

($20,000.00), the adequacy and receipt of which is

hereby acknowledged, BURNS agrees as follows:

1. BURNS releases any and all claims ALTON W.

BURNS and PAMELA A. BURNS may have upon the collateral.

After repossession of Arizona Marine, petitioner husband

testified that petitioners received roughly $15,000 of

"inventory", in addition to the $20,000 settlement check from the

Liebermans. Petitioner husband also testified that petitioners

paid their legal fees from the Arizona Marine transaction by

signing over the $20,000 settlement check to their attorney, and

paying approximately $3,000 to $4,000 out of their own pocket. 
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Petitioners did not introduce a copy of their 1980 Federal income

tax return to show how they treated the Arizona Marine

transaction.

Petitioners put "everything" they received from Arizona

Marine and Riviera "in the same storage deal". Petitioner

husband testified "I just figured I could probably sell it and

get my money back." At some point, petitioners leased the molds

to other boat builders. Eventually, petitioners got the molds

back from the lessees.

In 1985, petitioners claimed the $205,029 nonbusiness bad

debt deduction for the Arizona Marine and Riviera assets because

petitioners "perceived no value in that stuff at all at that

point in time." Petitioner husband further testified that in

1985, he came to the conclusion that:

I was not going to get any money out of this equipment

and there was two things that happened here, Your

Honor. One is I had gone through an audit in like 1976

with the IRS. When the IRS got through with the audit,

I ended up with a $32,000 tax credit and I had never

used all that tax credit up. So when I shut [Riviera]

down and Arizona Marine at the time, the losses, I

mean, I couldn't use them. So in 1985 was the first

time that I could even use any of these losses. So

determining that there was no value to any of that

equipment or stuff left, I went ahead and put it on my

income tax in 1985.

Subsequent years in '86 and '87 I sold some of the

stuff and, if you'll look at those tax returns, you'll

see I reported the income I received from the sale of

that equipment and molds.

Petitioners received $20,000 in 1986 and $25,000 in 1988

from these sales. Other than petitioner husband's general
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testimony above, petitioners did not introduce evidence to

identify the specific property sold on each of these dates, nor

did they identify whether they sold the property from Riviera or

Arizona Marine, or both, in each of these years.

On the Schedule D attached to their individual 1989 Federal

income tax return, petitioners reported capital gains of $32,087. 

They claimed a short-term capital loss carryover of $139,384,

which eliminated their capital gains for 1989. They then claimed

a capital loss of $3,000 on line 13 of their 1989 Form 1040. 

Respondent determined that petitioners were not entitled to a

short-term capital loss carryover of $139,384 because petitioners

had failed to establish their entitlement to the bad debt

deduction they claimed in a prior year. Respondent

correspondingly adjusted petitioners' 1989 income to include

$35,087 of capital gains.

Respondent's determinations in the statutory notice of

deficiency are presumed correct. Petitioners bear the burden to

prove error in those determinations. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).

With respect to the $205,029 bad debt deduction, petitioners

now concede that "such loss was not incurred in 1985 and that the

amount claimed is not correct. The actual loss was incurred in

1979, 1980, 1986 and/or 1988." Petitioners ask that the Court go

back to the years 1979, 1980, 1985, 1986 and/or 1988 to calculate

any loss they may have suffered in those years, so they may carry
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forward that loss to 1989. They argue that if a capital loss

were incurred in those years "which exceeded the current capital

gains and other application of capital losses during the period

from 1979 to 1988, the capital loss carryover created would be

capable of being carried into 1989 and offset the reported gain."

Petitioners are unclear about whether they are seeking a bad

debt deduction under the provisions of section 166, a loss

deduction under the provisions of section 165, or both with

respect to the Riviera and the Arizona Marine transactions. In

their trial memorandum, petitioners cite section 166(a), which

allows a deduction for a debt that becomes worthless within a

taxable year. They also cite section 165(g), which allows a

deduction for a security which becomes worthless during a taxable

year. On brief after trial, petitioners argue "there is little

significance to whether the loss constituted a short-term capital

loss under § 166(d)(1)(B) IRC or a long term capital loss as

described under § 1201 et.seq. IRC." They cite no other code

sections throughout their brief and reply brief.

The separate statutory provisions regarding losses and bad

debts are mutually exclusive. Spring City Foundry Co. v.

Commissioner, 292 U.S. 182, 189 (1934). Therefore, if a loss has

been sustained, the taxpayer may not deduct it as a bad debt. 

Moreover, deductions are not a matter of right but of legislative

grace. The burden is on the taxpayer to bring the case squarely
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within the precise terms of the statute. New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934).

To be entitled to a deduction for a loss or a bad debt for

any taxable year, petitioners must establish that their

transaction fits within the parameters of section 165 or section

166. Section 165 allows a deduction for any loss sustained by a

taxpayer which is not compensated by insurance or otherwise. In

the case of individuals, this deduction is limited to losses

incurred in a trade or business, losses incurred in a for-profit

transaction, and casualty or theft losses. Sec. 165(a), (c). 

The adjusted basis for the loss deduction is determined under

section 1011. A loss must be evidenced by closed and completed

transactions, fixed by identifiable events, and actually

sustained during the taxable year. Sec. 1.165-1(b), Income Tax

Regs.

The amount of loss allowable under section 165 shall not

exceed the taxpayer's basis in the asset. Fisher v.

Commissioner, T.C. Memo. 1986-141; sec. 1.165-1(c), Income Tax

Regs. The taxpayer bears the burden of proving the amount of the

taxpayer's basis in the asset. Millsap v. Commissioner, 46 T.C.

751, 760 (1966), affd. 387 F.2d 420 (8th Cir. 1968). A loss

cannot be computed where the taxpayer's basis in the property is

not proven. Fisher v. Commissioner, supra.

As mentioned, petitioners now concede that 1985 was not the

proper year to claim the $205,029 deduction. With respect to the
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Riviera transactions, the disposition of the alleged notes

occurred on October 31, 1979. The transactions relating to

Arizona Marine occurred on May 9, 1980. The losses suffered, if

any, would have been required to be reported on either

petitioners' 1979 or 1980 Federal income tax returns. The record

does not contain these returns. Accordingly, it is unclear how

petitioners treated these transactions on their returns.

In order to claim either of these alleged losses,

petitioners were required to establish the amount of that loss by

reference to their adjusted bases in the assets. Because we find

that petitioners did not establish their bases, the amount of

their losses, if any, cannot be computed. Sec. 165(b); Millsap

v. Commissioner, supra; Fisher v. Commissioner, supra. Although

nothing further need be said in light of these findings, we

address some of petitioners' contentions below.

Petitioners suggest that section 166 might apply to the

transactions at issue. In general, section 166(a) allows a

deduction for a debt which become worthless during the taxable

year. To be entitled to the deduction, the taxpayer must prove

the existence of a bona fide debtor-creditor relationship which

obligates the debtor to pay the taxpayer a fixed or determinable

sum of money. A contribution to capital cannot be considered

debt. Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 284

(1990); sec. 1.166-1(c), Income Tax Regs. The loss on the

worthlessness of a nonbusiness bad debt is deductible only as a
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short-term capital loss. Sec. 166(d). The amount of an allowable

bad debt deduction is governed by the adjusted basis of the debt

as determined under section 1011. Sec. 166(b).

Petitioners apparently concede that their advances to

Riviera were contributions to capital, rather than loans from

petitioners to Riviera. Our own review of the record leads us to

believe that the advances were in fact contributions to capital,

rather than loans. As the Court stated in Calumet Indus., Inc.

v. Commissioner, supra at 287, "We find that as an economic

reality the advances in the instant case were placed at the risk

of the business of the company and that it is unlikely that

disinterested investors would have made loans * * * on terms

similar to those on which the advances were made." Accordingly,

we do not consider section 166 applicable to the Riviera

transactions.

With respect to Arizona Marine, this Court has long held

that where there is a mutual agreement of settlement and the

agreement provides for the release of a debt for satisfactory

consideration, a bad debt deduction is not allowed. Harrison v.

Commissioner, 59 T.C. 578, 593 (1973); Northwest Equip. Co. v.

Commissioner, 34 B.T.A. 371 (1936). Aside from all else, we find

that the Arizona Marine obligation was released by petitioners in

exchange for satisfactory consideration in the form of money and

property. Therefore, this transaction does not entitle

petitioners to a bad debt deduction.
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Petitioners raised the possibility that section 165(g)

applies to the Riviera transaction. Section 165(g) provides that

if any security which is a capital asset becomes worthless during

the taxable year, the resulting loss shall be treated as a loss

from the sale or exchange of a capital asset. To be able to

deduct such losses, the petitioners must show: That the losses

were incurred; when the losses were incurred; that petitioners

are entitled to deduct such losses; whether the losses were

capital or noncapital, or business or personal; and, the amount

of capital gain during the intervening years, in order to compute

any allowable carryforward. Aazami v. Commissioner, T.C. Memo.

1993-436. Petitioners have not met these criteria. Thus, we

hold they are not entitled to claim a loss under section 165(g).

We further consider petitioners' reliance on section 6214 to

make the argument that they are entitled to currently claim

losses that may have occurred in prior years. In pertinent part,

section 6214(b) provides as follows:

The Tax Court in redetermining a deficiency of income

tax for any taxable year * * * shall consider such

facts with relation to the taxes for other years * * *

as may be necessary correctly to redetermine the amount

of such deficiency * * *

A taxpayer's failure to claim capital losses in prior years

does not necessarily result in the disallowance of deductions in

subsequent years. Lang v. Commissioner, T.C. Memo. 1983-318. 

However, the amount of any carryover loss is reduced in

accordance with section 1212(b), regardless of whether a
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deduction was taken in a prior year. Petitioners also bear the

burden to prove that the losses have not been previously

absorbed. Williams v. Commissioner, T.C. Memo. 1991-317, affd.

without published opinion 996 F.2d 1230 (9th Cir. 1993). When a

deduction is carried forward from one year to the next, the

taxpayer must keep records to substantiate the amount that is

carried forward. Sec. 1.6001-1(e), Income Tax Regs.

In the instant case, petitioners cannot show conclusively

that the losses, if any, would not have been previously absorbed. 

The pertinent transactions occurred as of October 31, 1979

(Riviera), and May 9, 1980 (Arizona Marine). Without access to

petitioners' Federal income tax returns or the relevant return

information for tax years 1979 and 1980, we find that it is

impossible to determine whether or not the losses were absorbed.

Based on the foregoing, we must conclude that petitioners

failed to carry their burden of proving that deductible losses

were suffered on the Riviera and Arizona Marine transactions. 

Petitioners have not offered sufficient evidence to prove their

bases in the assets they received from those transactions. 

Additionally, we find that they failed to carry their burden of

proving that any losses would not have been fully absorbed prior

to the year in question. With respect to these issues, we have

considered all arguments made by petitioners, and, to the extent

not addressed above, find them to be without merit.

To reflect the foregoing,
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Decision will be entered

under Rule 155.