t c memo united_states tax_court dana d messina and nancy g messina petitioners v commissioner of internal revenue respondent kyle r kirkland and stephanie layne petitioners v commissioner of internal revenue respondent docket nos filed date as of the tax_year m and k together owned of sec_1 an s_corporation which owned q a qualified_subchapter_s_subsidiary q was the borrower under a loan from an unrelated entity m and k formed sec_2 a wholly owned s_corporation to acquire the loan m and k contend that sec_2 should be disregarded for sec_1366 purposes and the loan deemed indebtedness of sec_1 to them allowing them to increase their bases in sec_1’s indebtedness and take into account its pass-through losses r maintains that sec_2’s separate corporate existence should be respected and the loan not be treated as indebtedness of sec_1 to m and k held sec_2 is not the incorporated_pocketbook of m and k held further sec_2 is neither an agent of m and k nor a conduit held further m and k had made an actual economic outlay to sec_2 which in turn made an actual economic outlay to sec_1 and q held further the step_transaction_doctrine does not apply held further m and k are bound by the form of their transaction newhall unitrust v commissioner 104_tc_236 aff’d 105_f3d_482 9th cir followed craig alan houghton for petitioners adam b landy audra m dineen and thomas r mackinson for respondent memorandum opinion laro judge these cases arise out of respondent’s adjustments to petitioners’ returns for the tax_year the cases were consolidated for trial briefing and opinion and were submitted fully stipulated under rule respondent determined a dollar_figure deficiency in dana d and nancy g messina’s federal_income_tax for the tax_year he also determined a 1unless otherwise indicated section references are to the internal_revenue_code code applicable for the relevant year rule references are to the tax_court rules_of_practice and procedure dollar_figure deficiency in kyle r kirkland and stephanie layne’s federal_income_tax for the same year the sole issue before this court is whether respondent properly disallowed the deduction by petitioners of certain pass-through losses from club one acquisition corp club one an s_corporation of which was owned by messrs messina and kirkland by reducing their respective adjusted bases in indebtedness of the corporation to them we hold that respondent’s disallowance of petitioners’ deduction of the pass-through losses is proper by the parties’ agreement respondent’s correlative adjustments are also upheld i overview background the parties submitted these cases fully stipulated under rule the first stipulation of facts and the facts drawn from stipulated exhibits and the stipulation of settled issues are incorporated herein petitioners are residents of california these cases are appealable to the court_of_appeals for the ninth circuit absent stipulation of the parties to the contrary ii club one’ sec_2012 tax_year during the tax_year club one had an ordinary business loss of dollar_figure of this amount dollar_figure was passed through to each of messrs messina and kirkland club one also had interest_income of dollar_figure of which dollar_figure was passed through to each of messrs messina and kirkland club one reported dollar_figure of deductible charitable_contributions for the tax_year dollar_figure of which was passed through to mr messina and dollar_figure of which was passed through to mr kirkland iii petitioners messrs messina and kirkland first met as colleagues at dabney resnick wagner in their first joint_venture was the acquisition of the selmer co they organized kirkland messina inc a california corporation on date as an investment advisory firm that assisted clients with arranging leveraged buyouts and corporate financing before their venture with club one out of which these cases arise messrs messina and kirkland provided investment advisory services to the bicycle casino in bell gardens california mr kirkland also provided investment advisory services to the commerce casino in commerce california and the vineyard casino in fowler california a dana and nancy messina mr messina is a graduate of tufts university with a degree in mechanical engineering and a graduate of harvard business school before attending harvard business school mr messina was employed as a nuclear engineer for combustion engineering he formerly held series serie sec_63 serie sec_24 and serie sec_27 securities licenses and was licensed in multiple state jurisdictions to initiate and handle securities transactions he is also an owner of glcr inc d b a deuce lounge and casino in visalia california mr and mrs messina timely filed a joint federal_income_tax return for the tax_year in preparing their return they used their adjusted_basis in club one stock and a dollar_figure adjusted_basis in club one’s indebtedness to them to claim deductions for the amounts of the losses charitable_contributions and other items passed through to them from club one for that tax_year mr and mrs messina reported itemized_deductions totaling dollar_figure on schedule a itemized_deductions of their return they also reported a foreign_tax_credit totaling dollar_figure on form_1116 foreign_tax_credit and a prior-year minimum_tax_credit totaling dollar_figure on form_8801 credit for prior year minimum tax--individuals estates and trusts to their return respondent audited the return and issued a 30-day_letter dated date proposing certain adjustments thereto mr and mrs messina timely challenged the proposed adjustments with the internal_revenue_service irs office of appeals the parties could not resolve the matter administratively and respondent on date issued a notice_of_deficiency in the notice_of_deficiency respondent reduced by dollar_figure the amount of losses mr and mrs messina could take into account for the tax_year thus increasing their taxable_income by that amount respondent further determined that mr and mrs messina’s itemized_deductions should be reduced by dollar_figure dollar_figure of which was attributable to a reduced charitable_contribution_deduction and dollar_figure to reduced excess miscellaneous deductions respondent also determined that mr and mrs messina no longer owe alternative_minimum_tax and are entitled to a dollar_figure minimum_tax_credit accordingly respondent determined a dollar_figure deficiency in mr and mrs messina’ sec_2012 federal_income_tax the parties have stipulated that all but the first of the adjustments are correlative or computational and should be resolved by this court’s decision with respect to the first adjustment which is the sole one at issue here mr and mrs messina timely petitioned this court for redetermination of the deficiency b kyle kirkland and stephanie layne mr kirkland graduated from harvard college in and the stanford graduate school of business in he formerly held series serie sec_63 serie sec_24 and serie sec_27 securities licenses and was licensed in multiple state jurisdictions to initiate and handle securities transactions mr kirkland is a board member and president of the california gaming association a trade organization representing licensed card rooms in the state of california he is also an owner of glcr inc d b a deuce lounge and casino in visalia california mr kirkland and ms layne timely filed a joint federal_income_tax return for the tax_year in preparing their return they used their adjusted_basis in club one stock and a dollar_figure adjusted_basis in club one’s indebtedness to them to claim deductions for the amounts of the losses charitable_contributions and other items passed through to them from club one for that tax_year mr kirkland and ms layne reported itemized_deductions totaling dollar_figure on schedule a of their return they also reported a foreign_tax_credit totaling dollar_figure on form_1116 attached to their return respondent audited the return and issued a 30-day_letter dated date proposing certain adjustments thereto mr kirkland and ms layne timely challenged the proposed adjustments with the irs office of appeals the parties could not resolve the matter administratively and respondent on date issued a notice_of_deficiency in the notice_of_deficiency respondent reduced by dollar_figure the amount of losses mr kirkland and ms layne could take into account for the tax_year thus increasing their taxable_income by that amount respondent further determined that mr kirkland’s and ms layne’s itemized_deductions should be reduced by dollar_figure of which dollar_figure was attributable to a denied deduction for net medical and dental expenses dollar_figure to a reduced charitable_contribution_deduction and dollar_figure to denied excess miscellaneous deductions respondent also adjusted mr kirkland’s and ms layne’s alternative_minimum_tax and determined that their foreign_tax_credit should be increased from dollar_figure to dollar_figure accordingly respondent determined a dollar_figure deficiency in mr kirkland’s and ms layne’ sec_2012 federal_income_tax the parties have stipulated that all but the first of the adjustments are correlative or computational and should be resolved by this court’s decision with respect to the first adjustment which is the sole one at issue here mr kirkland and ms layne timely petitioned this court for redetermination of the deficiency iv acquisition of club one casino inc casino a casino casino is a california corporation which since and throughout has operated a card room in fresno california licensed by the state of california before date casino was owned by george sarantos and elaine r long and taxed as an s_corporation for federal and state_income_tax purposes b club one club one is a california corporation organized on date since its incorporation it has elected to be taxed as an s_corporation for federal and state_income_tax purposes during date the following individuals acquired the listed numbers of shares of the issued and outstanding common_stock of club one which they continued to hold during the tax_year name number of shares ownership percent dana d messina kyle r kirkland george sarantos haig kelegian big_number big_number big_number big_number c club one’s acquisition of casino on date club one acquired from mr sarantos and ms long of the issued and outstanding_stock of casino this was accomplished by the merger of club one merger sub inc merger sub a california corporation and wholly owned subsidiary of club one into casino pursuant to a date stock purchase agreement between club one as buyer and mr sarantos and ms long as sellers the agreement provided for aggregate consideration of dollar_figure million subject_to certain purchase_price adjustments part of the consideration was to be paid in the form of two dollar_figure million promissory notes issued by merger sub one to mr sarantos and one to ms long each note bearing interest at the rate of per annum and due seven years from the sale’s closing date upon merger sub’s merger into casino club one became the owner of of casino’s issued and outstanding_stock and casino became the obligor under both promissory notes immediately after the merger having become a subsidiary of club one casino made an election to be treated for federal and state_income_tax purposes as the latter’s qualified_subchapter_s_subsidiary qsub d financing the acquisition club one’s acquisition of casino was funded in part by a loan of dollar_figure from d b zwirn special opportunities fund l p d b zwirn the loan was evidenced by a financing agreement dated date by and among club one merger sub casino and d b zwirn the latter as agent for the lenders at the time of the agreement’s execution d b zwirn was also the sole lender under the agreement the borrower was merger sub until its merger into casino whereupon casino became the borrower the financing agreement required that accrued interest be paid monthly in arrears on the first day of each month and the principal be repaid in quarterly installments until date when all amounts payable under the agreement were to become due immediately as evidenced by a security agreement and guaranty each dated date repayment of the d b zwirn loan was secured_by casino’s assets a pledge of of the stock of casino and the limited personal guaranties of messrs messina and kirkland under the financing agreement mr sarantos and ms long were required to execute a subordination agreement dated date under which they subordinated their respective promissory notes to the d b zwirn loan e state approval of the acquisition california law requires the owner of a gambling enterprise to be licensed by the state cal bus prof code secs and a west an owner that is a corporation cannot be licensed unless each officer director and shareholder other than a holding or intermediary company of the owner individually applies for and obtains a state gambling license id sec a the license should be obtained before engaging in a licensed gambling activity or occupying a position requiring licensure id sec messrs messina and kirkland believed that club one’s acquisition of casino required the approval of the california gambling control commission cgcc an agency of the state of california with jurisdiction over the operation concentration and supervision of gambling establishments and over all persons having to do with the operations of gambling establishments within the state see id sec the cgcc on date approved club one’s acquisition of casino and on date approved the issuance of gambling licenses to each of messrs messina kirkland sarantos and kelegian furthermore messrs messina and kirkland believed that d b zwirn’s loan to casino and merger sub’s pledge of casino stock to d b zwirn as collateral thereto also required the cgcc’s approval it is unlawful in california to enter into an agreement with a licensee in connection with a licensed gambling operation except as allowed by cgcc regulations id sec another statute provides that a purported sale assignment transfer pledge or other_disposition of any security issued by a corporation holding a gambling license is void unless approved in advance by the cgcc id sec on date and date the cgcc approved d b zwirn’s loan to merger sub and casino v postacquisition events a the d b zwirn loan on or about date fortress investment group llc fortress replaced d b zwirn co l p as the manager of various funds and accounts including among others d b zwirn in connection with this d b zwirn was converted into fortress value recovery funds i llc fortress fund during and casino paid additional_amounts to d b zwirn and the fortress fund to remain in compliance with certain loan covenants set forth in the financing agreement casino hoped to reduce the principal balance of the loan to improve its ability to refinance it with a new loan at a lower rate of interest or a longer maturity b refinancing the loan beginning in at least months before the d b zwirn loan’s date maturity_date messrs messina and kirkland attempted to find investors or lenders who would either refinance or acquire the d b zwirn loan from fortress fund before the loan matured in early mr messina contacted global hunter securities llc global hunter to assist casino and messrs messina and kirkland in finding such investors or lenders on date mr messina informed fortress representative clint lofman by electronic mail with copies to fortress representative bradley brown and to mr kirkland that it appeared on the basis of casino’s preliminary financial statements that casino would violate the earnings before interest taxes depreciation and amortization ebitda covenant in the financing agreement on date mr lofman stated to mr messina by electronic mail that he remained concerned about the ebitda covenant violation on date messrs messina and kirkland organized kmgi inc kmgi a california corporation to raise additional capital to either refinance or acquire the d b zwirn loan from the fortress fund since its incorporation kmgi has elected to be taxed as an s_corporation for federal and state_income_tax purposes the entity was organized with the assistance of robert s tabor formerly of the law offices of robert s tabor mr tabor in had served as california gaming law counsel to club one and reviewed the financing agreement to ensure its compliance with state gaming laws during and he served as kmgi’s consultant on california gaming issues because california law gives the cgcc power to approve or disapprove transactions involving gaming enterprises see cal bus prof code sec c west messrs messina and kirkland believed that kmgi could not acquire the d b zwirn loan from the fortress fund or lend money to casino without the cgcc’s prior approval in date messrs messina and kirkland through mr tabor began discussions with the cgcc to obtain approval to use kmgi to refinance a portion of the d b zwirn loan and during august of kmgi with mr tabor as consultant began the formal process of applying to the cgcc for approval to purchase some portion of the loan from the fortress fund on date mr kirkland transferred dollar_figure to kmgi in exchange for of its common_stock on date the cgcc authorized kmgi to purchase dollar_figure of the d b zwirn loan from the fortress fund on date mr kirkland lent dollar_figure to kmgi on that same day mr messina transferred dollar_figure to kmgi dollar_figure of which was used to acquire of its common_stock and dollar_figure of which was a loan kmgi recorded the transferred funds in its books_and_records as dollar_figure of capital stock and dollar_figure as shareholder loans the fortress fund however refused to sell the loan piecemeal insisting that any sale must be of the entire loan at the same time despite their efforts neither global hunter nor messrs messina and kirkland had been successful in finding an acceptable investor or lender who would refinance or acquire the loan before date neither mr messina nor mr kirkland had the personal liquidity to refinance or acquire the d b zwirn loan from the fortress fund during date however messrs messina and kirkland each closed the sale of all the stock they held in steinway musical instruments inc pursuant to a stock transfer agreement they had entered into on date this sale provided them with sufficient funds to acquire the loan from the fortress fund thus their 2although diamond creek capital llc expressed interest in acquiring the d b zwirn loan from the fortress fund the parties were unable to consummate the transaction due to disagreement about certain representations and warranties other efforts futile messrs messina and kirkland each agreed to acquire of kmgi’s stock and lend it sufficient funds to purchase the d b zwirn loan from the fortress fund on date mr kirkland met with kareem benjamin and jeff slahor from the fortress fund at fortress’ office in irving texas to discuss the d b zwirn loan’s acquisition messrs messina and kirkland believed that if they lent funds directly to casino to acquire the loan from the fortress fund the loan would not be senior in priority to the promissory notes held by mr sarantos and ms long without their consent similarly if they contributed funds to club one intending that the funds be lent to casino to repay the d b zwirn loan in full they would require mr sarantos’ and mr kelegian’s consent thereto however messrs messina and kirkland believed that if they lent money to kmgi to purchase and hold the d b zwirn loan repayment of the funds lent to kmgi would be senior to mr sarantos’ and ms long’s promissory notes which remained subordinated to the note backing the d b zwirn loan messrs messina and kirkland understood that any of these three options would require the cgcc’s prior approval before and during the tax_year neither of them had applied for or obtained authorization from the cgcc to lend money to casino or acquire any of its indebtedness and thus believed that they could not purchase the d b zwirn loan from the fortress fund in their individual capacities between date and date messrs messina and kirkland negotiated the purchase of the d b zwirn loan from the fortress fund because kmgi was authorized by the cgcc to acquire dollar_figure of the loan to avoid delays messrs messina and kirkland caused kmgi to agree to purchase the entire loan from the fortress fund subject_to the cgcc’s approval on date kmgi applied to the cgcc for approval to increase the amount of the loan it could purchase from dollar_figure to the estimated entire unpaid principal_amount that would be due under the loan as of the purchase date while the loan purchase negotiations were underway the fortress fund on date notified casino that events of default under the financing agreement had occurred as a result of the date filing of a writ of execution by mr sarantos and ms long against club one and the d b zwirn collateral and a date notice of amended judgment filed by mr sarantos and ms long by letter dated date the fortress fund notified casino and club one to cease all payments to mr sarantos and ms 3see infra for the background of club one’s dispute with mr sarantos and ms long out of which the amended judgment and writ of execution arose long and mr sarantos and ms long as subordinated creditors to immediately cease all attempts to a obtain funds or other assets from casino or club one or b enforce the writ of execution or amended judgment against casino or club one the fortress fund demanded that this cessation continue until the d b zwirn loan had been paid in full by notice dated date the fortress fund notified casino that it was exercising its right to convert and increase the interest rate on the loan effective date on date the fortress fund notified casino that certain payments to club one were restricted and could no longer be made on date the d b zwirn loan’s maturity_date all amounts payable under the financing agreement became immediately due and payable by casino to the fortress fund on date the fortress fund notified casino of an event of default in that the loan’s maturity_date had passed and demanded immediate payment of all amounts due also on date the fortress fund advised casino that its date interest payment was deficient in the amount of dollar_figure and demanded immediate payment thereof on date the cgcc authorized kmgi to purchase the entire d b zwirn loan from the fortress fund on date mr kirkland transferred dollar_figure and mr messina transferred dollar_figure to kmgi to provide it with a portion of the funds necessary to purchase the loan on date mr kirkland transferred an additional dollar_figure to kmgi kmgi recorded these transferred funds in its books_and_records as shareholder loans as of the dates messrs messina and kirkland completed the transfers as of date casino owed the fortress fund dollar_figure under the d b zwirn loan on date kmgi paid that amount to the fortress fund by wire transfer to acquire the loan pursuant to a loan purchase agreement dated that same day thus kmgi on date became the holder of the d b zwirn loan immediately after its acquisition of the loan kmgi on date released messrs messina and kirkland from any and all obligations under their personal guaranties on date kmgi transferred dollar_figure to mr kirkland and dollar_figure to mr messina for a total of dollar_figure representing the amounts of their earlier transfers that were not used to fund the purchase of the d b zwirn loan from the fortress fund on date casino paid dollar_figure of principal due under the d b zwirn loan to kmgi on that same day kmgi transferred dollar_figure each to messrs messina and kirkland for a total of dollar_figure as a payment on its shareholder loans also on date kmgi separately transferred dollar_figure to mr kirkland to reimburse him for the california minimum_tax that he had paid on its behalf upon the completion of all payments kmgi’s shareholder loans from messrs messina and kirkland had an unpaid principal balance of dollar_figure in preparing their federal_income_tax returns they treated their halves of this amount or dollar_figure each as their respective bases in a liability of club one owing to each of them and not as bases in kmgi on date kmgi’s bookkeeper posted an entry in the corporation’s books_and_records reclassifying the entire dollar_figure amount from shareholder loans to additional paid in capital on date mr kirkland lent an additional dollar_figure to kmgi which the corporation recorded in its books_and_records as an additional shareholder loan from mr kirkland as of that date since its incorporation kmgi has used a los angeles california address the same address as used for kirkland messina inc from its incorporation until date kmgi’s sole asset was cash contributed or lent by messrs messina and kirkland to fund the purchase of the d b zwirn loan from the fortress fund on and after date kmgi’s only assets excluding funds received from casino that were promptly paid or distributed to messrs messina and kirkland were the d b zwirn loan and a small amount of cash used to pay bank service charges and other nominal expenses in summary after kmgi became the holder of the d b zwirn loan on date it received the following payments from casino due under the loan during the tax_year date of payment amount of payment obligation paid dollar_figure big_number big_number big_number principal accrued interest and agency fee accrued interest and agency fee principal accrued interest and agency fee in turn kmgi paid or distributed the following amounts to its shareholders date of payment or distribution amount of payment or distribution dollar_figure dollar_figure big_number big_number big_number big_number nature of payment or distribution repayment of excess funds repayment of shareholder loans return_of_capital return_of_capital return_of_capital return_of_capital amount_paid or distributed to messina dollar_figure amount_paid or distributed to kirkland dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number --- --- big_number in early messrs messina and kirkland applied to the cgcc for approval to acquire the d b zwirn loan from kmgi on date the cgcc authorized an assignment of partial_interests in the loan allowing messrs messina and kirkland to purchase the d b zwirn loan from kmgi c dispute with the sellers after club one’s acquisition of casino club one discovered certain discrepancies in casino’s financial statements provided by mr sarantos and ms long before closing along with several previously undisclosed operational and legal issues club one believed that these discrepancies and issues violated the sellers’ representations and warranties made in connection with the stock purchase agreement consequently club one requested a reduction in the casino purchase_price mr sarantos and ms long rejected the proposed reduction and requested an increase in the purchase_price which club one in turn rejected club one and mr sarantos and ms long submitted their dispute to binding arbitration for resolution as required by the stock purchase agreement on date the arbitrator issued an interim award ruling against club one denying its proposed purchase_price_adjustment and granting the sellers’ proposed_adjustment on date the arbitrator issued an interim award granting attorney’s fees and costs to mr sarantos and ms long on that same day counsel for the sellers sent correspondence to club one requesting immediate payment of the interim arbitration awards on date the arbitrator issued a final award incorporating the interim awards after oral notice and correspondence with club one’s controlling shareholders the fortress fund sent a letter dated date to club one mr sarantos and ms long stating that notwithstanding the arbitration award the parties to the financing agreement remained subject_to the subordination agreement executed by mr sarantos and ms long and the arbitration award was subordinated indebtedness the fortress fund emphasized that an order issued by the arbitrator to club one or casino to pay the award would constitute an event of default under the financing agreement in which event no subordinated debt could be repaid including any interest payments under the sellers’ promissory notes accordingly the fortress fund prohibited club one and casino from paying the arbitration award of purchase_price adjustments until there was no event of default continuing or paying the arbitration award of interest attorney’s fees and other costs until all obligations under the financing agreement had been paid in full on date mr sarantos and ms long obtained a judgment in the fresno county superior court confirming the final arbitration award the judgment was amended on date see amended judgment sarantos v club one acquisition corp no 11cecg02432 cal super ct date on date club one filed an action in the supreme court of the state of new york for new york county seeking to affirm that mr sarantos’ and ms long’s arbitration award judgment and promissory notes were subject_to the subordination agreement on date that court ruled that while the promissory notes were subordinated the arbitration award was not see post-trial decision and order club one acquisition corp v sarantos no n y sup ct date on date club one and kmgi as intervenor appealed certain portions of the court’s ruling to the appellate division of the new york supreme court on date club one and casino separately filed a voluntary petition under chapter of title of the u s code in the u s bankruptcy court for the eastern district of california the casino bankruptcy petition listed mr sarantos’ and ms long’s promissory notes as disputed claims of dollar_figure in date club one casino mr sarantos and ms long reached a settlement regarding among other things the dispute surrounding the promissory notes that same month club one and kmgi withdrew their appeal of the new york supreme court’s ruling discussion i overview the operative points of these cases can be summarized tersely as follows as of the tax_year messrs messina and kirkland owned of an s_corporation club one which in turn owned a qsub casino the qsub was the borrower under the d b zwirn loan messrs messina and kirkland organized another s_corporation kmgi of which they were the sole shareholders to acquire the d b zwirn loan this was intended to make repayment of the loan to kmgi senior to casino’s repayment of the promissory notes to mr sarantos and ms long thus the indebtedness of club one and its disregarded qsub casino was held not directly by messrs messina and kirkland but indirectly through kmgi petitioners argue that kmgi should be disregarded and the d b zwirn loan deemed to be indebtedness of club one to messrs messina and kirkland this would allow petitioners to count their adjusted bases in the loan in calculating the amounts of club one’s flow-through losses they can deduct for the tax_year respondent urges this court to conclude that kmgi’s separate corporate existence should be respected and that the d b zwirn loan should not be treated as indebtedness of club one to messrs messina and kirkland we agree with respondent ii legal background sec_1366 generally provides that an s corporation’s shareholder takes into account for his taxable_year in which the corporation’s taxable_year ends his pro_rata share of the corporation’s items of income loss deduction or credit as well as the corporation’s non-separately computed income or loss the character of the items passed through is preserved sec_1366 however the aggregate amount of losses and deductions taken into account by the shareholder is limited it may not exceed the sum of the adjusted_basis of the shareholder’s stock in the s_corporation and the shareholder’s adjusted_basis of any indebtedness of the s_corporation to the shareholder sec_1366 any disallowed loss or deduction is treated as incurred by the corporation in the succeeding taxable_year with respect to that shareholder sec_1366 a qsub is a domestic_corporation which is not an ineligible_corporation under sec_1361 is owned by an s_corporation and elects to be treated as a qsub sec_1361 under sec_1361 a qsub generally is not treated as a separate corporation and all of its assets liabilities and items of income deduction and credit are treated as assets liabilities and such items of the s_corporation thus for purposes of sec_1366 a qsub’s debt issued to its parent s corporation’s shareholder is treated as the parent’s debt to determine the amount of losses that may flow through to the parent’s shareholders h_r rept no pincite 1996_3_cb_331 the code does not define indebtedness of the s_corporation to the shareholder as used in sec_1366 the legislative_history of the statute’s predecessor states that losses are limited 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 s rept no 1958_3_cb_922 this court has construed investment in the sec_1366 context to mean an actual economic outlay of the shareholder see eg 110_tc_62 citing 103_tc_711 the shareholder bears the burden of establishing his basis in the indebtedness of the s_corporation to him 137_tc_46 aff’d 727_f3d_621 6th cir in these cases we need not address whether under sec_7491 the burden_of_proof has shifted from petitioners to respondent because first petitioners have not so contended and second these cases having been submitted under rule there are no outstanding factual issues relevant to ascertaining petitioners’ tax liability--the only issues that remain are legal ones as to which the burden_of_proof is irrelevant see petersen v commissioner t c ___ ___ slip op pincite date iii acquisition of basis in indebtedness of club one respondent argues that a basis in an s_corporation can be acquired either by contributing capital or directly lending funds to the company see 174_f3d_928 8th cir the loan must be direct respondent maintains and thus no basis is created where funds are lent by a separate_entity even one closely related to the shareholder in question see id pincite respondent relies on this court’s caselaw for that proposition see hitchins v commissioner t c pincite t he indebtedness of the s_corporation must run directly to the shareholders an indebtedness to an entity with passthrough characteristics which advanced the funds and is closely related to the taxpayer does not satisfy the statutory requirements 59_tc_172 clearly there must be a debt running directly to the shareholder in order to permit the deduction from income of a corporate net_operating_loss see also 61_tc_343 aff’d without published opinion 506_f2d_1051 3d cir thomas v commissioner tcmemo_2002_108 aff’d 67_fedappx_582 11th cir burnstein v commissioner tcmemo_1984_74 lee v commissioner tcmemo_1976_265 35_tcm_1157 respondent emphasizes that the d b zwirn loan ran to club one and casino from kmgi not from messrs messina and kirkland according to respondent all the evidence indicates that the debt does not run directly from the shareholders to club one and casino and so cannot be considered in computing the bases of any indebtedness of club one to messrs messina and kirkland for their part petitioners concede that this court and others have interpreted sec_1366 generally to require that indebtedness of an s_corporation be owed directly to the shareholder however petitioners assert form is but one-half of the inquiry and the transaction’s substance also needs to be considered thus petitioners posit that caselaw allows an intermediary such as kmgi to be disregarded where it is acting as the taxpayer’s incorporated_pocketbook is a mere conduit or agent of the taxpayer or has failed to make an actual economic outlay to the loss s_corporation that has made the intermediary poorer in a material sense as a result of the loan petitioners also argue that the step_transaction_doctrine should apply to determine the true creditor in the transaction for federal_income_tax purposes we address petitioners’ theories in turn a incorporated_pocketbook petitioners urge that this court find that kmgi acted as the incorporated_pocketbook for messrs messina and kirkland in purchasing the d b zwirn loan from the fortress fund and holding it thereafter petitioners rely on a theory distilled from caselaw as summarized in broz v commissioner t c pincite that direct payments from a related_entity to the taxpayer’s s_corporation constitute payments on the taxpayer’s behalf where the taxpayer used the related_entity as an incorporated_pocketbook see yates v commissioner tcmemo_2001_280 culnen v commissioner tcmemo_2000_139 rev’d on other grounds 28_fedappx_116 3d cir this court has held that the term incorporated_pocketbook refers to the taxpayer’s habitual practice of having his wholly owned corporation pay money to third parties on his behalf and that whether an entity is an incorporated_pocketbook is a question of fact see broz v commissioner t c pincite citing ruckriegel v commissioner t c memo while petitioners acknowledge that messrs messina and kirkland did not habitually use kmgi to pay their personal expenses or to pay casino’s expenses they argue that this court’s caselaw suggests that habitual use of a corporate entity to make payments on an s_corporation shareholder’s behalf is not a requirement but merely evidence that indebtedness runs directly to the shareholder petitioners also emphasize that unlike the entities in culnen or yates kmgi had no business activities other than holding the d b zwirn loan and acting as a conduit for payments made by casino respondent on the other hand asserts that messrs messina and kirkland ought to be bound by the form of the transaction they have chosen see burnstein v commissioner tcmemo_1984_74 47_tcm_1100 a transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred quoting 429_us_569 see also thomas v commissioner tcmemo_2002_108 wl at ordinarily taxpayers are bound by the form of the transaction they have chosen taxpayers may not in hindsight recast the transaction as one that they might have made in order to obtain tax advantages quoting 902_f2d_439 5th cir aff’d without published opinion 67_fedappx_582 11th cir moreover respondent points out where the entities involved in transactions are owned wholly by the taxpayer that taxpayer bears a heavy burden of demonstrating that the substance of the transactions differs from their form ruckriegel v commissioner tcmemo_2006_78 wl at citing bergman f 3d pincite respondent also argues that the incorporated_pocketbook cases cited by petitioners culnen and yates do not apply here first respondent maintains that line of cases deals with frequent and habitual payments made on behalf of the taxpayer by the related_entity often for personal expenses second he contends those cases involved back-to-back loans where a related_entity lends or distributes assets to the taxpayers followed by a loan from the taxpayer to the s_corporation there this court found that the payments were not in substance direct loans from the related_entity to the s_corporation with the taxpayer serving as a mere conduit from the transfer of funds here respondent asserts there was a one-time transfer from each of messrs messina and kirkland to kmgi followed by a single payment to acquire the d b zwirn loan all of this being insufficient to demonstrate a habitual practice of the entity paying on its owners’ behalf we agree with respondent the incorporated_pocketbook rationale is inapposite here in both of the cases petitioners cite--culnen and yates--the taxpayers sought to regularly direct funds from one of their entities through themselves and on to an s_corporation here petitioners concede that messrs messina and kirkland did not use kmgi habitually to pay casino’s or their personal expenses instead they argue that this is not a requirement but only evidence_of_indebtedness running directly to the shareholder to the extent we would agree with that statement the fact that kmgi did not make payments habitually does not help petitioners’ case to the contrary it would be evidence against a finding that indebtedness runs from club one and casino directly to messrs messina and kirkland at any rate we disagree with petitioners’ interpretation of culnen and yates frequent and habitual payments are key to a finding that a corporation served as an incorporated_pocketbook kmgi did not make frequent and habitual payments on behalf of its shareholders accordingly we find that it did not function as messrs messina and kirkland’s incorporated_pocketbook b conduit or agent petitioners cite 485_us_340 for the proposition that corporations when serving as agents of taxpayers may be ignored for tax purposes in bollinger the taxpayers formed two corporations to secure financing at higher rates than allowed by state usury laws under a nominee agreement the corporations held title to real_property as the taxpayers’ agents for the sole purpose of securing financing and had no assets liabilities employees or bank accounts commissioner v bollinger u s pincite the real property’s operation over several tax years generated income and losses which were reported by the taxpayers on their tax returns id the supreme court held that the corporations were agents of the taxpayers who in turn were entitled to claim the real_property income and losses directly the supreme court determined that to reach such a result the agent-principal relationship must be genuine as evidenced by a written_agreement setting forth the fact that a corporation is acting as agent for its shareholders with respect to a particular asset the corporation’s functioning as agent and not principal with respect to the asset for all purposes and the corporation’s holding itself out as the agent and not principal in all dealings with third parties relating to the asset id pincite petitioners point out that in lee v commissioner t c m cch pincite n this court suggested that in a true conduit or agency situation such as with a nominee a loan running through a corporate intermediary may be considered to run directly from the shareholder instead for purposes of the predecessor to sec_1366 petitioners argue that their cases involve facts similar to those in bollinger and that this court’s suggestion in lee should be brought to bear here petitioners emphasize that messrs messina and kirkland contributed to kmgi which had no assets or other business activity besides the loan acquisition all the funds necessary to purchase the d b zwirn loan and that kmgi served effectively as a conduit for payments from casino petitioners also contend that messrs messina and kirkland advised the parties involved in the loan acquisition that kmgi was purchasing the loan on behalf of messrs messina and kirkland and that doing so allowed the cgcc to grant its approval to the transaction more quickly than if the two owners had applied to cgcc in their individual capacities petitioners thus would have us hold that kmgi acted as agent for messrs messina and kirkland in purchasing the d b zwirn loan from the fortress fund respondent retorts that this court in past cases such as in hitchins or burnstein or thomas has been reluctant to apply the agency exception to the rule that indebtedness must run directly from the s_corporation to its shareholder moreover respondent argues club one casino kmgi and messrs messina and kirkland were sophisticated parties who consulted with their counsel and advisers before undertaking the d b zwirn loan purchase from the fortress fund respondent points out that they consciously chose the form of the transaction to maintain the d b zwirn loan’s seniority with respect to other casino obligations respondent asserts that the record does not indicate that the cgcc or any other third party was aware of kmgi’s being an agent for messrs messina and kirkland nor was any agency agreement executed the corporate minutes of club one and kmgi do not reflect any agency relationship respondent also emphasizes that messrs messina and kirkland were released from their individual guaranties of the d b zwirn loan upon kmgi’s acquisition thereof finally respondent believes that the record shows that kmgi conducted itself as a principal in its interactions with the cgcc fortress and other parties we agree with respondent that kmgi did not act as agent of messrs messina and kirkland the supreme court has set forth several factors to consider when evaluating whether a corporation is another’s agent whether it operates in the name and for the account of the principal whether it binds the principal by its actions whether it transmits money received to the principal whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal whether its relations with the principal depend upon the principal’s ownership of it and whether its business_purpose is the carrying on of an agent’s normal duties 336_us_422 in commissioner v bollinger u s pincite the supreme court found it sufficient to establish the existence of agency that there was a written_agreement setting forth that a corporation was acting as agent for its shareholders with respect to a particular asset it functioned as agent and not principal with respect to the asset for all purposes and it was held out as agent and not principal in all dealings with third parties relating to the asset this court has held that the nine indicia put forward in nat’l carbide and bollinger are not dispositive requirements for agency status but rather factors leading to the conclusion that that status exists in a given case see barnhart ranch co v commissioner tcmemo_2016_170 at in reviewing the nat’l carbide and bollinger indicia we conclude that no agency relationship existed between kmgi and messrs messina and kirkland we examine each of the nine factors in turn first the record demonstrates that kmgi while owned by messrs messina and kirkland operated in its own name and for its own account for instance it stood on its own in its dealings with the cgcc and was the sole purchaser of the d b zwirn loan from the fortress fund kmgi had its own bank accounts and held shareholders and directors meetings in short it was very much a separate_entity this factor does not favor petitioners second petitioners have presented no evidence of any instance where kmgi bound messrs messina and kirkland by its actions indeed on acquiring the d b zwirn loan kmgi in its role as counterparty immediately released its shareholders from their personal guaranties of the loan thus unbinding them from any personal responsibility therefor this factor does not favor petitioners third while kmgi did promptly transmit to messrs messina and kirkland substantially_all the funds received in relation to the d b zwirn loan it was under no legal or contractual obligation to do so this factor is neutral for petitioners at best favoring them weakly fourth kmgi’s income was attributable to an asset that it held the d b zwirn loan the income was attributable to neither messrs messina and kirkland’s services nor assets belonging to them this factor does not favor petitioners fifth kmgi’s relations with messrs messina and kirkland depended on their ownership thereof their contribution to kmgi of the funds necessary to acquire the d b zwirn loan initially was classified by kmgi on its schedule of shareholder loans as a loan from shareholders and later treated as additional paid in capital similarly the payments from kmgi to messrs messina and kirkland were classified on the corporation’s cashflow statement as repayment of shareholder loan and subsequently as return_of_capital distribution of income thus the financial flows between kmgi and messrs messina and kirkland were as those between a corporation and its lenders or shareholders not as between an agent and its principal this factor does not favor petitioners sixth kmgi’s business_purpose was to hold the d b zwirn loan and maintain the related note’s seniority to mr sarantos’ and ms long’s promissory notes kmgi did not have a business_purpose of carrying on an agent’s normal duties this factor does not favor petitioners seventh there is no evidence of any agreement written oral or implied establishing kmgi as an agent for messrs messina and kirkland this factor does not favor petitioners eighth kmgi acted as principal in relation to the d b zwirn loan for instance it was the sole purchaser of the asset from the fortress fund and alone received all payments due under the terms of that loan no other person not even mr messina or mr kirkland had any legal or contractual right to or interest in the asset this factor does not favor petitioners and ninth kmgi was not held out as an agent of messrs messina and kirkland in its dealings with third parties there is nothing in the record to suggest otherwise while it may have been known to others that kmgi wa sec_4petitioners make much of a part of mr sarantos’ date deposition testimony in the course of the new york state court_proceeding where he alluded to his belief that it was messrs messina and kirkland not kmgi who purchased the loan from the fortress fund q a q a you’re aware that sometime in the spring of kmgi purchased the loan from fortress are you not sir you mean kirkland and messina don’t you no i said kmgi i know what you said but it’s kirkland and messina continued funded owned and controlled by messrs messina and kirkland funding ownership or control is insufficient to establish an agency relationship else every closely held entity and subsidiary would be considered its owner’s or parent’s agent an absurd result indeed messrs messina and kirkland had every incentive to place as much separation between themselves and kmgi as they could for purposes of the arbitration between club one and mr sarantos and ms long and the subsequent action in new york state court this factor does not favor petitioners petitioners have at most established the existence of one of the nine nat’l carbide and bollinger indicia with respect to kmgi’s relationship with messrs messina and kirkland this is inadequate to persuade us that this relationship wa sec_4 continued q so in your view the corporate form doesn’t matter a i would imagine it’s going to come into play q when you incorporated george sarantos inc did you expect that folks would understand that they’re dealing with a corporation rather than you personally a anybody that dealt with gs management got george sarantos this deposition testimony however does not address whether kmgi was held out as the agent of messrs messina and kirkland that of an agent to its principals the weight of the factors instead shows kmgi to be a distinct corporate entity accordingly we find that kmgi was not messrs messina and kirkland’s agent nor was it a conduit c actual economic outlay petitioners argue that kmgi--similarly to the taxpayers in cases such as bergman and 357_f3d_854 8th cir aff’g tcmemo_2002_172 where the court_of_appeals for the eighth circuit determined that to increase his basis in an s_corporation the stockholder must make an actual economic outlay and be left poorer in a material sense--made no actual economic outlay to purchase the d b zwirn loan rather petitioners maintain it was messrs messina and kirkland who provided the funds used by kmgi to purchase the loan petitioners emphasize that messrs messina and kirkland fully owned and controlled kmgi and were released from their guaranties of the loan upon its acquisition by the corporation moreover they assert kmgi was a shell corporation with no business or other activity besides holding the d b zwirn loan and the corporation’s net_worth both before and after the loan’s acquisition was approximately dollar_figure the amount of mr messina’s and mr kirkland’s initial capital contributions petitioners add that kmgi functioned as a conduit for payments received from casino retaining only nominal amounts to pay bank charges and other de_minimis expenses consequently petitioners urge that we find that kmgi made no actual economic outlay in purchasing the d b zwirn loan on behalf of its shareholders and that it was not poorer in a material sense afterwards because all the funds used to purchase the loan had been lent to it by messrs messina and kirkland respondent argues that messrs messina and kirkland each made an actual economic outlay and contribution to kmgi and that the amounts they contributed to kmgi were reclassified from shareholder loans to additional paid-in capital which increased their bases in the stock of kmgi see 131_tc_262 generally a shareholder in an s_corporation has a tax basis in his stock equal to the amount of the contributions he makes to the capital of the s_corporation and the shareholder’s capital contributions are not included in the income of the s_corporation aff’d 615_f3d_83 2d cir thus respondent maintains the amounts contributed to kmgi by messrs messina and kirkland minus any repayments of shareholder loans before date when the dollar_figure of outstanding shareholder loans was reclassified by kmgi’s bookkeeper to additional paid-in capital were capital contributions see id pincite respondent points out that this reclassification is borne out by the journal entries in kmgi’s general ledger and kmgi’ sec_2012 federal_income_tax return accordingly respondent contends that we should hold that mr messina and mr kirkland made capital contributions to kmgi thereby increasing their stock bases in that corporation and thus cannot use the same contribution dollars to increase their debt bases in club one respondent also disputes petitioners’ characterization of kmgi as a shell corporation arguing that messrs messina and kirkland had a significant business_purpose in structuring the transaction as they did the maintenance of the d b zwirn loan’s seniority to mr sarantos’ and ms long’s promissory notes we agree with respondent that messrs messina and kirkland did make actual economic outlays see eg thomas v commissioner tcmemo_2002_ wl at and that these outlays were to kmgi petitioners by their argument about actual economic outlay essentially rehash the conclusion of their other two theories that kmgi was nothing more than a conduit or incorporated_pocketbook that ought to be disregarded we have already disposed of those theories kmgi was a corporation with its own separate existence likewise it was not simply a shell corporation but a distinct entity with at least one substantial asset the d b zwirn loan and a significant business_purpose cf ashdown v commissioner tcmemo_1989_40 56_tcm_1160 n neither party defined the term shell corporation although each of them used it we assume it means a corporation which has no assets or has assets of very little value although it appears to be prosperous and successful on paper and the reclassification from shareholder loans to additional paid-in capital of mr messina’s and mr kirkland’s contributions of funds to kmgi in its books_and_records is further evidence as to the transaction’s substance mr messina’s and mr kirkland’s capital contributions combined with kmgi’s other indicia of actual corporate existence are compelling evidence of economic outlay taxpayers generally are bound to the form of the transaction they have chosen see newhall unitrust v commissioner 104_tc_236 i t is well established that taxpayers are ordinarily bound by the form of their transaction while the government can attack that form if it does not represent the substance of the transaction aff’d 105_f3d_482 9th cir see also eg 113_tc_1 generally taxpayers are bound to the form of their transaction petitioners have failed to establish that messrs messina and kirkland should not be held to the form of the transaction they deliberately chose therefore any economic outlays by messrs messina and kirkland are fairly considered to have been made to kmgi a distinct corporate entity which in turn made an economic outlay to club one and casino d step_transaction_doctrine petitioners also argue that we should apply the step_transaction_doctrine see 324_us_331 to hold that messrs messina and kirkland and not kmgi became the new holders of the d b zwirn loan after its purchase from the fortress fund petitioners look to 85_tc_397 as an instance of this court’s reliance on the step_transaction_doctrine to ignore the formation sale and liquidation of an s_corporation in support of their position they assert that kmgi’s only substantial asset had been and was the d b zwirn loan that kmgi was a conduit and that it released messrs messina and kirkland from their personal guaranties of the loan something that a third-party purchaser of the loan would not have done respondent disputes petitioners’ application of the step_transaction_doctrine to these cases arguing that messrs messina and kirkland consciously and intentionally chose the form of the transaction and should not be able to argue against their own form to achieve a more favorable tax result respondent adds that kmgi was not an agent of or a mere conduit for messrs messina and kirkland thus respondent argues the form and the substance of the d b zwirn loan acquisition are the same and the step_transaction_doctrine should not apply we agree with respondent petitioners’ step_transaction_doctrine argument is yet another permutation of their other theories of which we have disposed kmgi was not messrs messina and kirkland’s incorporated_pocketbook nor was it their agent or a conduit each had made an actual economic outlay to kmgi and they intended that the corporation be respected as an entity distinct and separate from them there is no ambiguity in their intent nor is there ambivalence in messrs messina and kirkland’s care to organize and maintain kmgi as a discrete body corporate cf 875_f2d_420 4th cir aff’g 90_tc_206 long has the rule been recognized by the courts that taxpayers are bound by the form of their transaction and may not argue that the substance triggers different tax consequences id pincite see also 417_us_134 this court has observed repeatedly that while a taxpayer is free to organize his affairs as he chooses nevertheless once having done so he must accept the tax consequences of his choice whether contemplated or not while taxpayers might at first blush plead inequity that they may not attack the form of their transactions while the government can do so see newhall unitrust v commissioner t c pincite i t is well established that taxpayers are ordinarily bound by the form of their transaction while the government can attack that form if it does not represent the substance of the transaction such an argument is doomed to fail taxpayers have the benefit of forethought and strategic planning in structuring their transactions 69_f2d_809 2d cir any one may so arrange his affairs that his taxes shall be as low as possible he is not bound to choose that pattern which will best pay the treasury there is not even a patriotic duty to increase one’s taxes aff’d 293_us_465 whereas the government can only retrospectively enforce its revenue laws although the step_transaction_doctrine is not a one-way ratchet and taxpayers in certain instances may benefit from it too 422_f3d_1339 n fed cir see also 271_fsupp2d_1061 s d ohio indeed the step_transaction_doctrine is not merely a method preventing tax_avoidance but can also be used for a taxpayer’s benefit sooner fed sav loan ass’n cl_ct that the step transaction rule cuts both ways has been generally assumed and decided petitioners’ cases do not present such an instance indeed petitioners misconstrue the step_transaction_doctrine perhaps confusing it with broader substance-over-form principles of which the step_transaction_doctrine is but one part see eg 144_tc_161 ndollar_figure we have described the step_transaction_doctrine for example as simply an extension or application of the ‘substance over form’ doctrine 88_tc_1415 the step_transaction_doctrine is in effect another rule_of substance over form under the step_transaction_doctrine interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction 489_us_726 the acquisition of the d b zwirn loan consisted of only two steps mr messina’s and mr kirkland’s transfers of funds to kmgi and the latter’s purchase of the loan from the fortress fund kmgi did not go on to resell the loan to messrs messina and kirkland or any other entity therefore there was no step the consolidation of which with the other steps would allow the d b zwirn loan to be treated as running directly from messrs messina and kirkland to club one and casino accordingly we find that petitioners may not invoke the step_transaction_doctrine to hold that messrs messina and kirkland and not kmgi became the holders of the d b zwirn after its acquisition from the fortress fund iv conclusion we have found that kmgi was not messrs messina and kirkland’s incorporated_pocketbook nor was it their conduit or agent messrs messina and kirkland had made actual economic outlays to kmgi which in turn made an actual economic outlay to club one and casino and the step_transaction_doctrine does not apply to cause kmgi to be disregarded in messrs messina and kirkland’s transactional arrangement accordingly we hold that the form of the d b zwirn loan’s acquisition corresponds to its substance and should be respected for federal tax purposes as it was implemented petitioners have not carried their burden of establishing that mr messina’s and mr kirkland’s bases in club one’s indebtedness to them were other than those determined by respondent by the parties’ stipulation respondent’s correlative adjustments also are upheld we have considered all of the parties’ arguments and to the extent not discussed above conclude that those arguments are irrelevant moot or without merit to reflect the foregoing decisions will be entered for respondent