T.C. Memo. 1997-52

UNITED STATES TAX COURT

NORTON M. BOWMAN, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6078-95. Filed January 28, 1997.

Herman C. Daniel III, for petitioner.

Deborah C. Stanley, for respondent. 

MEMORANDUM FINDINGS OF FACT AND OPINION

WELLS, Judge: Respondent determined a deficiency of $37,684

in petitioner's 1988 Federal income tax. The issues we must

decide are: (1) Whether a distribution received by petitioner
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1 Petitioner alleged in his petition that the period of

limitations for assessment and collection of his 1988 income tax

had run by the time the notice of deficiency in the instant case

was issued. Petitioner made no argument on brief concerning that

allegation, and we consider it abandoned. Rybak v. Commissioner,

91 T.C. 524, 566 n.19 (1988).

2 Unless otherwise indicated, all Rule references are to the

Tax Court Rules of Practice and Procedure, and all section

references are to the Internal Revenue Code as in effect for the

year in issue.

during 1988 constituted a repayment of a loan or a dividend and

(2) the amount received by petitioner.1 

FINDINGS OF FACT

Some of the facts have been stipulated for trial pursuant to

Rule 91.2 The parties' stipulations of fact are incorporated

herein by reference and are found as facts in the instant case.

At the time the petition was filed in the instant case,

petitioner resided in Richmond, Virginia. 

Norton M. Bowman and Associates, Inc. (Associates) was

organized pursuant to Virginia law during the late 1970's. 

During all relevant times, petitioner controlled Associates as

its president, chief executive officer, and sole stockholder. 

Associates engaged in the business of constructing single-family

homes in the Richmond area. From the time of its organization

until 1981, Associates constructed 15 to 18 houses. The profits

earned from the sale of those houses were used to meet the

escalating costs of subsequent jobs and were not distributed. 

Prior to the time of the distribution in issue, which occurred on
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March 24, 1988, petitioner received no salary or dividends from

Associates. 

Soon after its organization, Associates obtained from United

Virginia Bank (bank), later known as Crestar Bank, a $150,000

line of credit that funded Associates' operations. The line was

secured by three certificates of deposit, two of which, in the

aggregate amount of $130,000, were in the name of petitioner, and

one of which, in the amount of $20,000, was in the name of

petitioner's wife. During January 1981, the bank called the

line, and the certificates of deposit in petitioner's name were

redeemed during that month and used to satisfy the indebtedness

(sometimes hereafter referred to as the 1981 transaction). The

amount of those certificates exceeded Associates' indebtedness to

the bank by a few thousand dollars, and petitioner retained that

excess. The certificate in the name of petitioner's wife was not

used to pay Associates' debt. Associates did not obtain another

line of credit. At that time, petitioner did not desire to

continue building houses because the housing market was not

strong and interest rates were between 18 and 19 percent.

Petitioner's attorney drew up an unsecured demand note

(note) that bore no interest. The note was made on those terms

because petitioner did not know when improved business conditions

would enable Associates to resume operations. The note was among

items that were subsequently lost in a flood. Associates' assets

at the time that the note was drawn up included building lots and
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a model home that was used to demonstrate the features that could

be incorporated in the homes it constructed. Associates also

owed $40,000 to trade creditors with respect to a house under

construction. Associates' assets were otherwise unencumbered at

relevant times. Associates' income tax return for its fiscal

year ended September 30, 1981 (1980 corporate return), reported

that debts due its officers increased from $3,006.86 for the year

ended September 30, 1980, to $126,008.16 for the year ended

September 30, 1981. 

During 1982 and 1983, petitioner devoted his time to a

travel business rather than to the building business, but by 1985

the housing market had revived sufficiently to cause petitioner

to resume Associates' business of building houses. On March 24,

1988, Associates paid petitioner $117,164.91 of its funds, which

were deposited into an investment savings account in petitioner's

name (hereinafter sometimes referred to as the 1988

distribution). The distribution represented the proceeds of a

closing on a house sold by Associates. The distribution was made

because Associates was doing well and did not need the money. 

Petitioner considered that the amount of the distribution

approximated the amount he thought was due him from Associates. 

The funds were pledged as collateral for a line of credit in

favor of Associates. Petitioner did not report the distribution

as income on his 1988 income tax return because he considered it

the repayment of a debt owed him by Associates. 
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3 As discussed below, we consider petitioner to have received

only one distribution from Associates during 1988.

Associates' income tax return for the year ended September

30, 1988 (1987 corporate return), reported that its indebtedness

to shareholders decreased by $125,000 during that year. 

OPINION

The principal issue presented for decision in the instant

case is whether the distribution3 petitioner received from

Associates during 1988 was a loan repayment or a dividend. If we

decide that the distribution was a dividend, and therefore

taxable income, the question of the amount received must also be

decided.

In order to ascertain the nature of the 1988 distribution,

we must decide whether, based on reliable indicia of the

intrinsic economic nature of the transaction, there was a genuine

intention that the 1981 transaction create a debtor-creditor

relationship between Associates and petitioner. Alterman Foods,

Inc. v. United States, 505 F.2d 873, 877 (5th Cir. 1974); Road

Materials, Inc. v. Commissioner, 407 F.2d 1121, 1124-1125 (4th

Cir. 1969), affg. on this issue T.C. Memo. 1967-187; KohlerCampbell Corp. v. United States, 298 F.2d 911, 913 (4th Cir.

1962); Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 378
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(1973). If the 1981 transaction was a bona fide loan by

petitioner to Associates, the 1988 distribution is a repayment of

the loan, but if the 1981 transaction was a contribution to

Associates' capital, the 1988 distribution is a dividend. The

inquiry into whether the 1981 transaction resulted in a loan to

Associates or a contribution to its capital is one of fact. Road

Materials, Inc. v. Commissioner, supra at 1124; Segel v.

Commissioner, 89 T.C. 816, 827 (1987).

Because there is no controlling statute or regulation

defining the difference between corporate debt and equity, we are

left to decide the question based on a series of factors that

courts have relied upon in distinguishing between the two. Segel

v. Commissioner, supra at 826-827. Those factors include: (1)

the names given the certificates evidencing the purported

indebtedness; (2) the presence or absence of a fixed maturity

date; (3) the source of repayments; (4) right to enforce

payments; (5) participation in management as a result of

advances; (6) the status of the persons advancing funds in

relation to regular corporate creditors; (7) the intent of the

parties; (8) identity of interest between stockholder and

purported creditor; (9) the "thinness" of capital structure in

relation to debt; (10) the ability of the corporation to obtain

credit from outside sources; (11) the use to which the advances

were put; (12) the failure of the purported debtor to repay; and
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(13) the risk involved in making the advances. Dixie Dairies

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

No single factor is controlling, nor is each equally

significant, or even relevant, in the circumstances of a

particular case. Id. at 493-494. Our task is not to count

factors, but to evaluate them. Slappey Drive Ind. Park v. United

States, 561 F.2d 572, 581 (5th Cir. 1977). "Each case turns on

its own facts; differing circumstances may bring different

factors to the fore." Id. The 1981 transaction must be

measured by objective tests of economic reality, and the

touchstone of economic reality is whether an outside lender would

have made a loan to Associates in the same form and on the same

terms as the 1981 transaction. Segel v. Commissioner, supra at

828.

The entire record must be considered, especially where, as

here, the person in control of the nominal debtor is also the

nominal creditor, and the arm's-length dealing that characterizes

the money market is absent. Road Materials, Inc. v.

Commissioner, supra at 1124. In distinguishing between loans to

a corporation and contributions to its capital, courts have noted

that a creditor avoids subjecting funds advanced to the risk of

the business insofar as possible and seeks a reliable return,

while a shareholder places an investment at that risk and obtains

a return from the business' success. Slappey Drive Indus. Park

v. United States, supra at 581; Jewell Ridge Coal Corp. v.
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4 It is also not conclusive that, by paying off the credit

(continued...)

Commissioner, 318 F.2d 695, 698 (4th Cir. 1963), affg. T.C. Memo.

1962-194.

We have considered all of the factors set forth above, as

well as all of the circumstances revealed by the record, and

discuss below those we find most pertinent. We note first that

the 1981 transaction was cast in the form of a loan. Petitioner

points out that the note was prepared as evidence of Associates'

obligation to repay petitioner, although the note was not

produced at trial due to its loss in a flood. Associates' books

were not introduced in evidence; however, its relevant tax

returns report an increase and decrease in its indebtedness that

may reflect the 1981 transaction and 1988 distribution. 

Petitioner also testified that he made a "loan" to Associates

during 1981 that was "repaid" during 1988. 

The existence of a debt, however, does not necessarily

follow. Road Materials, Inc. v. Commissioner, supra at 1124. 

The law requires more than "a declaration of intention to create

an indebtedness and more than the existence of corporate paper

encrusted with the appropriate nomenclatural captions." Tyler v.

Tomlinson, 414 F.2d 844, 850 (5th Cir. 1969). The 1981

transaction will not be treated as a debt for Federal tax

purposes merely because it is evidenced in a manner that Virginia

law recognizes as debt.4 Road Materials, Inc. v. Commissioner,
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4 (...continued)

line, petitioner may have stepped into the shoes of the bank as

Associates' creditor pursuant to the equitable doctrine of

subrogation. The question whether the 1981 transaction was a

loan or effected a contribution to Associates' capital must be

resolved based on whether or not, considering all of the

circumstances in the record, petitioner intended to create a

debtor-creditor relationship between Associates and himself. In

re Lane, 742 F.2d 1311, 1319-1320 (11th Cir. 1984); Santa Anita

Consol., Inc. v. Commissioner, 50 T.C. 536, 550 (1968); Kavich v.

United States, 507 F. Supp. 1339, 1342 n.2 (D. Neb. 1981). 

Petitioner admits as much on brief. Moreover, petitioner cannot

use the doctrine to appropriate for himself the bank's status as

a bona fide creditor of Associates. 

supra at 1124. Furthermore, when a transaction involves a

closely held corporation, the form and labels assigned to the

transaction may not have much significance because the parties

can mold the transaction to their will. Anchor Natl. Life Ins.

Co. v. Commissioner, 93 T.C. 382, 407 (1989). It is the

substance of the transaction, rather than the form, that controls

for tax purposes. Road Materials, Inc. v. Commissioner, supra at

1124.

Circumstances other than the form of the loan indicate that

the substance of the 1981 transaction did not accord with its

form. The note was payable on demand and did not have a fixed

maturity date because, as petitioner explained, he was unsure

when business conditions would enable Associates to resume

operations. The absence of a fixed maturity date indicates that

repayment was tied to the fortunes of the business, which

suggests that the 1981 transaction effected a contribution to

Associates' capital. In re Lane, 742 F.2d 1311, 1316 (11th Cir.
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1984); Estate of Mixon v. United States, 464 F.2d 394, 404 (5th

Cir. 1972); American Offshore, Inc. v. Commissioner, 97 T.C. 579,

602 (1991). 

Moreover, the 1981 transaction occurred when Associates was

suspending business activities due to weakness in the market for

new homes. Petitioner indicated in his testimony that he did not

intend to make a demand for payment and expected that he would be

paid when market conditions improved. However, the record does

not suggest when that improvement might occur. In fact,

Associates did not resume operations until 1985, and petitioner

testified that he did not receive a distribution from Associates

until 1988. The foregoing circumstances indicate that there was

no reasonable expectation that "repayment" of petitioner's "loan"

would occur within a short time. Accordingly, the absence of a

fixed maturity date given Associates' business prospects

indicates that the 1981 transaction was in the nature of a

contribution to its capital. In re Lane, supra at 1316.

Petitioner contends that Associates had sufficient assets to

"repay" his "loan" both at the time that it was made and

subsequently, indicating that Associates was adequately

capitalized and that a reasonable expectation of repayment

existed. Assuming arguendo that Associates' assets were

sufficient for that purpose, it is reasonable to conclude that a

demand for payment would have stripped Associates of assets

needed to carry on its business, such as the model home which it
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used to demonstrate the features that could be built into the

houses it constructed for its customers or the building lots on

which those homes would be erected. Associates appeared not to

have expendable assets that could have been used to pay

petitioner without detriment to its business; rather, any assets

used to pay petitioner apparently would have had to have been

replaced if Associates were to continue in business. The absence

of liquid assets or of reasonably anticipated cash-flow out of

which to make repayments indicates that the 1981 transaction was

a contribution to capital rather than a loan. Segel v.

Commissioner, 89 T.C. at 830-831. Moreover, petitioner's

testimony indicates that he did not intend to demand payment

until business conditions for Associates improved and its assets

could be sold at full value. Petitioner's position as sole

shareholder of Associates, his concern for its welfare, and the

consequences of a demand for repayment indicate that it was

unlikely that such a demand would be made, and thus the

circumstances pointed to by petitioner do not indicate a

creditor's interest in repayment. Tyler v. Tomlinson, supra at

849; Dixie Dairies Corp. v. Commissioner, 74 T.C. at 495. The

fact that petitioner left the funds at the risk of Associates'

business suggests that he did not intend to demand payment to the

detriment of that business. 

Petitioner did not obtain a security interest in any of

Associates' assets in connection with the 1981 transaction. 
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Petitioner testified that he was Associates' sole stockholder and

that his control of the corporation was such that he could have

caused it to make a distribution "repaying" his "loan" at any

time. We conclude from petitioner's testimony that he relied on

his control of Associates as a stockholder to protect his

interests, rather than his status as a creditor, which indicates

that the 1981 transaction effected a contribution to Associates'

capital. Charter Wire, Inc. v. United States, 309 F.2d 878, 881

(7th Cir. 1962).

Additionally, the note did not provide for payment of

interest with respect to petitioner's "loan", even though, at the

time of the 1981 transaction, interest rates ranged between 18

and 19 percent, nor does the record suggest that a payment of

interest ever occurred. Petitioner's apparent indifference to

the receipt of interest suggests that he is not a true lender but

is principally concerned with the future earnings of Associates

or its increased market value. Slappey Drive Ind. Park v. United

States, 561 F.2d at 582; Segel v. Commissioner, supra at 833. 

The timing of the 1988 distribution also indicates that the

1981 transaction effected a contribution to Associates' capital

rather than a loan. That distribution did not occur until more

than 7 years after the 1981 transaction, and nothing in the

record suggests that Associates similarly delayed payments of its

bona fide debts. O.H. Kruse Grain & Milling v. Commissioner, 279

F.2d 123, 126 (9th Cir. 1960), affg. T.C. Memo. 1959-110. 
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Moreover, petitioner testified that the distribution was made

because Associates was doing well and did not need the money

distributed. A distribution of funds under such circumstances

points to an equity classification because a corporation normally

declares dividends only when it has ample cash, and shareholders

ordinarily acquiesce in such a policy due to their primary

concern for the health of an enterprise and its long-term

success. Slappey Drive Ind. Park v. United States, supra at 582. 

Petitioner's statement indicates that he possessed the

motivations of a shareholder and believed it appropriate to

decide when to make payments on the same basis that corporations

customarily use to make dividend decisions. Id. Moreover,

Associates had never distributed a dividend, or paid a salary, to

petitioner prior to the distribution in issue. The foregoing

circumstances suggest that the 1981 transaction resulted in a

contribution to Associates' capital, rather than a loan. Id.

We believe that an outside lender would not have made a loan

to Associates on the terms given by petitioner. We conclude that

the characteristics of the 1981 transaction and the 1988

distribution were substantially at variance with those of a

normal debt transaction, indicating that the 1981 transaction did

not result in a loan as a matter of economic reality. Segel v.

Commissioner, supra at 833-834.

We have considered the remaining factors and circumstances

in the record, and, to the extent they are pertinent, they are
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either neutral or do not outweigh the circumstances set forth

above that indicate that the 1981 transaction effected a

contribution to Associates' capital rather than a loan. 

Moreover, petitioner has neither shown nor argued that the

distribution to him cannot be characterized as a dividend in

whole or part because Associates lacked earnings and profits. 

Consequently, we shall assume that Associates had sufficient

earnings and profits for purposes of this case. Based on our

consideration of the entire record, we find that the distribution

received by petitioner from Associates during 1988 constituted a

dividend rather than a repayment of a loan.

We next consider the amount of the dividend distributed by

Associates. Respondent determined that the amount of the

dividend was $125,000, based on the 1987 corporate return, which

reported a decrease in loans to Associates from its shareholder

in that amount. Petitioner admits that he received $117,164.91,

an amount to which the parties have stipulated, but contends,

relying on his testimony, that he received no more than that

amount. Petitioner could not explain why the 1987 corporate

return reported the $125,000 decrease in liabilities. 

Although petitioner's testimony concerning the transactions

in issue lacked sufficient detail in some respects, we found him

to be credible. Moreover, the information reported on the

corporate returns that purportedly reflects the transactions in

issue is not consistent. The 1980 corporate return reports an
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5 Respondent notes that the 1987 corporate return may reflect

payments made during calendar year 1987 as well as the

distribution that occurred during 1988 because Associates used a

tax year ending Sept. 30, 1988. However, any distribution that

petitioner might have received during 1987 would not be taxable

to him for 1988, the year in issue. Petitioner, moreover,

testified that he received no distributions from the corporation

prior to 1988. 

increase in shareholder loans of approximately $123,000, while

the 1987 corporate income tax return reports a decrease in those

loans of $125,000.5 The record does not suggest that any

transactions other than the ones in issue could have affected

those figures. Moreover, petitioner testified that he accepted a

sum approximating the amount he had paid on Associates' behalf in

settlement of his "loan". Petitioner may therefore have received

only the distribution to which the parties have stipulated while

Associates may have treated the full amount of the "loan" as

having been discharged for reporting purposes regardless of any

discrepancy between the two amounts.

 

Accordingly, we find that petitioner received only

$117,164.91 from Associates during 1988.

To reflect the foregoing,

Decision will be entered

under Rule 155.