TAX COURT OPINION

Case: Indmar Products Co., Inc.
Docket Number: 15428-03
Judge: Foley
Opinion Type: memo
Filed: 02/23/2005
Pages: 10

| CAL, S. T. JUDGE T.C. Memo. 2005-32 UNITED STATES TAX COURT INDMAR PRODUCTS CO., INC., Petitioner v. COMMISSIONER .0F JNTERNAL- REVENUE, "Respondent . t Docket No."-.15428-03c . o FiledCFêbruary 23, 2005. Matthew P. Cavitch and Gerald P. Arnoult, for petitioner. Kirk S. Chaberski, for respondent. nMENÓRANDUM EINDINGSaOFnFACT9ANDi.OPINION n , FÖLEY, Müdge : aBy /notice, dated5July 3;x2003, respbndent determined deficiericies iñ, .andrpenalties related to, petitiöner's 1998 1999µand '2000 Federalgincomé~taxés After concessionst byf res} ondent,othe .remaining. issues fórodecisibn are whether: (1) The cash transfers to petitioner were.loans or capital investments; and, (2). petitioner .is (liable4for section SERVED JEB 2 3 2005 od3 mcW.13tålent-oí e o (cid:16)042+ai First Tennessee Bank (FTB) e r nn.1 aWI e åndn p c,<6 .n± ne -ww novo£ (i.e., petitioner s main creditor) requiring petitioner to ~maintain a certain ratio of current , bluow ·teno: f1 teo Fd.NadFopS'elr6¾Íc ibbe %#r 59voi f ~' a±wo I MC ßdhoAmstV Q:n<Kt 1;(cid:16)060·néW·th!I uë%-*ìtn(cid:16)060Tâ·Øu ò?ò(cid:0)523Sa assets to current 11ab111tles. In 1989, petitioner s accountant, Wesley Holmes, decided no itnuduna jthyoi- MÚ¢hB'4 sdota hn anM%nFsw9 & sw . that petitioner needed documentation to support the reporting of 0-ssMyr M ..M¾ofocuche à¾. AnnemdW wf m, M. the transfers as long-term liabilities. Mr. Holmes "cietermined ·7^ntúnMar..510%Pv4GbM' A et½QJod WD$rsrWà aa that the transfers could be reported as long-term liabilities If _. . tteiwfm v ÚF+n8½DuA t t coMM. -sddloo x the Rowes signed a walver agreeing to f c.c.:n v.,ni17e.?) bocbèM'attWhh dr* least 12 months. L 2sq.%f oc ©nuóqo!. .t%debf t #dfEowe r r.drng.ppNaugdohl hÉ fál le petitioner's financial statements $1sclosed that -9%e oft¼:. the notes to From 1989 through 2000, Jo repayment for at ,.icIuMs The ehewabföranstd Gnmb tt M 13nka*Oct@4mIQik stockholders have agreed not to demand payment withlin the "next r c year", and in 1992 and 1993, 'the Rowes signed written agreements add oc^bná£tio brain300nceM6Wh%h#nWsa#4m.45ms,8- ed ..J4a stating that they would not demand repayment of the- transfers a-Lawnad3GbMd (waivers). Despite these disclosures and agreements, 1 A Júca c.02OOnTJQúåO4dafun3A . demanded and receive seven par al dS3S94.dPé'f.!'2A OnÁWh .dAfÒe-Cit'I5da the Rowes repaymen s to a ing {ÒóM b * b a 4 $1, 105, 169 . Petitioner record d in its books andtrecords, all transfers as "notes payable - stockholders" and reported, -on its Federal of Jnscast; income tax returns, scCah.Wobeff$ h th~~e mon y paymen s to stockhol ers as- a flhMÁW d 2 interest expense deduction. Consistent 'wlth p titioner s u . òdt don% ótid/ v TVoS8 in M1 SDfW %M4A"díU 4.3 treatment of the mont'Ély payments, the Yowes reported (1.e., *on 3n . r $1onol.1'ace . -their-individual.-Income tax returns) , 0 di Ac hpei-' f Il income Outstanding _ notes payabl'e - stockholders .½ sptbeta f - <'± etJdt*ru¬ + e W ,, .uo3orr bdaini¾, avaw e·-a4»rtrc + ~ (cid:16)042· ser i .w ë* >+- -r these payments as interest. dehneate"d 'in et ti ne s 1 86 fi ncÝa atYmeÝtFì- tafe?$2dM5^0^0 a^r d - 5 - reached a high of $1,779,169 in 1991. In 1993, Richard Rowe, Jr., and Joseph Tidwell made a transfer of $25,000 and $18,000, respectively, but also demanded repayment of $110,000 and $26,000, respectively, for education expenses. In 1998, Donna Rowe demanded repayment of $180,000 for boat repairs. Mr. Rowe, in 1994 and 1995, demanded repayment of $15,000 and $650,000, respectively, to pay his taxes and purchase a home. Mr. Rowe also demanded repayment of $84,948, $80,000, $25,000, and $70,221 . in 1997, 1998, 1999, and 2000, respectively, to pay litigation, boat repair, and tax expenses. The Rowes, in 1997 and 1998, made additional transfers to petitioner of $500,000 and $300,000, respectively. The balance of "notes payable - stockholders" on December 31, 2000, totaled $1,166,912.2 In 1993, Mr. Holmes determined that a promissory note should be executed for a portion of the previously undocumented transfers from the Rowes. Petitioner, on December 31, 1993, executed a promissory note (1993 note) with Donna Rowe for $201,400 (i.e., her outstanding balance) of the $1.5 million total outstanding balance of the transfers. The 1993 note was payable on demand, was freely transferable, had no maturity date or payment schedule, and had a stated interest rate of 10 2 This amount also reflects a net decrease of $214,088 that was reported in 1992. how many transfers and/or repayments were made during that year or which stockholders were involved in the 1992 -transactions. The record, however, is not clear as to - 6 - percent. On November 21, 1995, petitioner executed a promissory note (1995 note) with Mr. Rowe for $605,681 (i.e., his outstanding balance) of the $807,081 total outstanding balance of the transfers. The 1995 note was payable on demand, was freely transferable, had no maturity date or payment schedule, and had a stated interest rate of 10 percent. On January 1, 1998, when the outstanding transfers totaled $1,222,133, petitioner executed two written line of credit agreements with the Rowes for $1,000,000 and $750,000. The line of credit agreements provided that the balances were payable on demand, and the notes were freely transferable. In addition, the agreements provided a stated interest rate of 10 percent and had no maturity date or payment schedule. Petitioner was profitable, and numerous banks sought to lend petitioner money. As a result, FTB worked diligently to retain petitioner's business, made funds immediately available upon petitioner's request, and was willing to lend petitioner 100 percent of the transferred amounts. FTB, however, required petitioner to subordinate (i.e., to FTB's outstanding loans with petitioner) all transfers. In 1993, FTB lent petitioner $1,850,000. The loan agreement stated "no payments shall be made by Borrower to satisfy any * * * [stockholder] indebtedness for so long as the Loans shall remain unpaid." Petitioner, however, made partial repayments to - 7 - stockholders while FTB loans remained outstanding. On November 21, 1995, when the prime rate was 8.5 percent, petitioner borrowed $650,000 from FTB, at 7.5 percent, to pay Mr. Rowe. In 1997, petitioner and FTB executed a promissory note for $1,000,000 that was modified in 1998. The interest rate on the note was below the prime rate. At the time the petition was filed, petitioner's principal place of business was located in Millington, Tennessee. OPINION Respondent contends that petitioner's interest expense deductions relating to payments made to the Rowes should be disallowed because the transfers were capital investments and not loans. Petitioner contends that the transfers were loans. Taxpayers are entitled to a deduction for payments made on bona fide indebtedness that relates to an existing, unconditional, and legal obligation to repay. Sec. 163(a); Burrill v. Commissioner, 93 T.C. 643 (1989). Petitioner bears the burden of proving that the transfers are debt and not equity.3 . Rule 142(a); Smith v. Commissioner, 370 F.2d 178, 180 (6th Cir. 1966), affg. T.C. Memo. 1964-278. Transfers between related parties are examined with special scrutiny when taxpayers contend that such transfers are loans. 3 Sec. 7491(a) the net worth requirements of sec. 7430(c)(4)(A)(ii), which is inapplicable because petitioner does not meet are cross-referenced in sec. 7491(a')(2)(C). - 8 - Roth Steel Tube Co. v. Commissioner, 800 F.2d 625, 630 (6th Cir. 1986), affg. T.C. Memo. 1985-58. In determining the economic reality of a related party transfer, "'the ultimate issue is * * * whether the transaction would have taken the same form had it been between the corporation and an outside lender'". Fed. Express Corp. v. United States, 645 F. Supp. 1281, 1290 (W.D. Tenn. 1986) (quoting Scriptomatic, Inc. v. United States, 555 F.2d 364 (3d Cir. 1977)). The more a transfer appears to result from an arm's-length transaction, the more likely the transfer will be considered debt. Bayer Corp. v. Mascotech, Inc., 269 F.3d 726, 750 (6th Cir. 2001). In distinguishing between debt and equity, courts also analyze whether the contemporaneous facts establish an unconditional obligation to repay. Roth Steel Tube Co. v. Commissioner, supra at 630; Smith v. Commissioner, supra at 180; see Burrill v. Commissioner, supra at 669. In Roth Steel, the Court of Appeals for the Sixth Circuit used an 11-factor test to determine whether the transfer was debt or equity.4 No factor is (3) source of payments, (4) name given (1) Identity of interest between 4 The 11 factors are: creditor and stockholder, capitalization, instruments evidencing indebtedness, fixed maturity date and schedule of.payments, absence of a fixed rate of presence or absence of security, financing, absence of a sinking fund, and (11) extent to which the transfers were used to acquire capital assets. Roth Steel Tube Co. v. (6) presence or (7) interest and interest payments, (8) inability to obtain outside (9) subordination of transfers, (10) presence or (2) adequacy or inadequacy of (5) presence or absence of (continued...) controlling ,or decisive by~itself sand the -particular circumstances of each case must be considered_ by .the court. Roth Steel Tube Co. va Commissioner, supra at 630. "These ,factors are merely tools to beyused in evaluating hether the transaction as a whole was effected with a genuinewintention to create a3debt, .., with a reasonable expectation of repayment, and within the economic realities of a debtor-creditor rela onsl lp." ñÄcklitis T v. Commissioner, 91 T.C. 874, 905 (1988). I. c The Rowes' Obiectives for Characterizing. the Cash Transfers *as .Debt The Rowes' .,characterized the¿cash transfers as,debt.,because_ they wanted to re.ceive a 10-perceng return. on.. their investment and minimize estate taxes. Mr.cRowe testified,that they,received advice .fromanumerous estate planners and decided tos chara,cterize the transfers as loans because "we felt, additiorial equity ou d only hurt thes family at pur+death." p£or nearly312 of the 14 years,cfrom 1987o to 2000, ther10-·percent_ rate charged b the Rowes- was abov.ehthe market and prime int_erest, rates. For example ini1998 yhen the priame rategas 8.5 percent, petitio3ne executed loang agreements with he &owes4 and..FTB at fixed rates f 10 and 7.5 percenty respectiyelyy, Mr,. Rowe testiQe unconvincingly, that the higher rate ,charged by4.the Rowes 4'( . . . continued) Commissioner, 800 F.2d 625, 630-632 (6th Cir. 1986) affg. T.C. Memo. 1985-58. . maos a sw n : . sq . - 12 - Thus, the transactions between petitioner and the Rowes did not take the same form as transactions between unrelated parties. IV. The Roth Steel Test In addition to the transfers not being arm's-length transactions, the 11-factor test set forth in Roth Steel Tube Co. v. Commissioner, 800 F.2d 625 (6th Cir. 1986), establishes that the transfers were equity. First, petitioner did not pay any formal dividends. Jaques v. Commissioner, 935 F.2d 104, 106 (6th Cir. 1991), affg. T.C. Memo. 1989-673. Second, pursuant to 12 consecutive years of waivers, there was no fixed maturity date or fixed obligation to repay. Roth Steel Tube Co. v. Commissioner, supra at 631; Jaques v. Commissioner, supra at 108 (stating that a taxpayer's failing to repay debt within a reasonable time and making "sporadic" principal payments are factors that weigh in favor of equity). Third, Mr. Rowe testified that petitioner was expected to make a profit and that repayment "has to come from corporate profits or else the company couldn't pay for it." Roth Steel Tube Co. v. Commissioner, supra at 631 (stating "An expectation of repayment solely from corporate earnings is not indicative .of bona fide debt regardless of its reasonableness." (citing Lane v. United States, 742 F.2d 1311, 1314 (11th Cir. 1984))). Fourth, the transfers were unsecured. Roth Steel Tube Co. v. Commissioner, supra at 631. Finally, petitioner never established a sinking fund. Id. at 632. These factors certainly - 13 - outweigh the factors in favor of characterizing the transfers as debt (e.g., petitioner reported the payments on its Federal income tax returns as interest expense, external financing was available, petitioner was adequately capitalized, the transfers were not subordinated to all creditors, and the.Rowes did not make the transfers in proportion to their respective equity . holdings). Moreover, petitioner failed to establish that, at the time the transfers were made, it had the requisite unconditional and legal obligation to repay the Rowes (e.g., the transfers were not documented). Thus, we conclude that the Rowes' transfers were equity. Accordingly, petitioner is not.entitled to an interest expense deduction relating to the years in issue. Respondent also determined that petitioner is liable for a section 6662(a) accuracy-related penalty. The penalty applies to the portion of petitioner's underpayment that is attributable to a substantial understatement of income tax. Sec. 6662 (b) (2) . Respondent established that petitioner understated its income tax liability, and thus, respondent has met his burden of production, pursuant to section 7491(c). Petitioner, however, failed to address this issue on brief and did not present any credible evidence to establish that it acted in good faith or that there was reasonable cause for claiming the interest expense deductions. Accordingly, the accuracy-related penalty is applicable to the underpayment attributable to the stockholder payments. - 14 - Contentions we have not addressed are irrelevant, moot, or meritless. To reflect the foregoing, Decision will be entered under Rule 155.