Opinion ID: 2973623
Heading Depth: 4
Heading Rank: 4

Heading: The Source of Repayments

Text: “An expectation of repayment solely from corporate earnings is not indicative of bona fide debt regardless of its reasonableness.” Roth Steel, 800 F.2d at 631 (emphasis added). Repayment can generally come from “only four possible sources . . .: (1) liquidation of assets, (2) profits from the business, (3) cash flow, and (4) refinancing with another lender.” Bordo Prods., 476 F.2d at 1326 (quoting Plumb, supra, at 526). The Tax Court found that the “source of repayments” factor favored equity. It relied upon Richard Rowe’s testimony that Indmar was expected to make a profit and that repayment “has to come from corporate profits or else the company couldn’t pay for it.” Indmar, 2005 T.C.M. LEXIS 31, at . The full colloquy from the testimony, however, is more equivocal: 3 The Tax Court did count in favor of debt the fact that Indmar consistently reported the payments as interest expense on its federal taxes. 4 The Tax Court was troubled by the treatment of the advances in the company’s records as both demand debt and long-term debt. While we share the Tax Court’s concerns, this was not the issue before the Tax Court or us on appeal. Importantly, regardless of whether it classified the payments as demand debt or long-term debt, the company at all times identified the advances as some form of debt. We leave it to the Tennessee authorities to determine whether Indmar owes any state taxes or penalties as a result of its reporting and accounting practices. No. 05-1573 Indmar Prods. Co. v. Comm’r Page 9 Q. . . . [A]t the time that you made these advances, were you anticipating that the repayment was going to come from corporate profits? A. Yes, sir. It has to come from corporate profits or else the company couldn’t pay for it. Unless it made profit – and I have always believed from the first day we started, that we were going to be profitable. Q. Was it your understanding and intent, at the time you made these advances, that if the company was not, in fact, profitable, you would not be repaid? A. I had no intentions of not being repaid, sir. Q. Why is that? A. I believe it’s me. It’s my personality. Q. Is that because you intended to make a profit? A. Yes, sir. There are at least two plausible ways to read this testimony. One can read it the way the Tax Court apparently did – Rowe’s testimony was, at best, contradictory: repayment must come from profits, but he had no intention of not being repaid, regardless of the company’s fortunes. Given the apparent contradiction, one should focus on the statement against Indmar’s interest: Rowe admitted that repayment of the advances “has to come from corporate profits or else the company couldn’t pay for it.” If repayment “has” to come from profits, then this would imply that repayment was tied to the company’s fortunes, suggesting the advances were equity contributions. Another way to read the testimony, however, is that Rowe, as a small businessman and unsecured creditor, believed that full repayment of all of Indmar’s debt required a thriving, successful business, which, ultimately, required profits. In other words, struggling companies near or at bankruptcy do not repay their debts, at least not dollar for dollar. Under this reading, his testimony is consistent with debt. In fact, we sounded a similar note in an earlier decision addressing the debt/equity issue: “One who makes a loan to a corporation also takes a risk, and while he may receive evidence of an obligation, payable in any event, often such obligation is never paid. . . . ‘All unsecured loans involve more or less risk.’” Byerlite, 286 F.2d at 292 (quoting Earle v. W.J. Jones & Son, Inc., 200 F.2d 846, 851 (9th Cir. 1952)). If there was no other evidence to support one view or the other, we could not say that the Tax Court’s reading was clearly erroneous. Credibility determinations are left to the fact finder, and our review on appeal is strictly limited. The “Tax Court ‘is not bound to accept testimony at face value even when it is uncontroverted if it is improbable, unreasonable or questionable.’” Lovell & Hart, Inc. v. Comm’r, 456 F.2d 145, 148 (6th Cir. 1972) (quoting Comm’r v. Smith, 285 F.2d 91, 96 (5th Cir. 1960)). On the other hand, the Tax Court cannot ignore relevant evidence in making its factual findings and any inferences from those findings. Here, there is undisputed testimony by Rowe and the FTB lending officer, corroborated by stipulated evidence in the record, that clearly weighs in favor of debt on this factor. Indmar repaid a significant portion of the unpaid advances – $650,000 – not from profits but by taking on additional debt from FTB. While the interest rate on the FTB loan was lower than 10%, Indmar had to secure the bank loan with inventory, accounts and general intangibles, equipment, and personal guarantees. Thus, Indmar repaid a significant portion of the unsecured stockholder advancements by taking on secured debt from a bank, rather than by taking the funds directly from earnings. This is important evidence that the parties had no expectation that Indmar would repay the advances No. 05-1573 Indmar Prods. Co. v. Comm’r Page 10 “solely” from earnings. The Tax Court did not discuss or even cite this evidence in its Roth Steel analysis. 5. The Extent to Which the Advances Were Used to Acquire Capital Assets Nor did the Tax Court address whether Indmar used the advances for working capital or capital expenditures. “Use of advances to meet the daily operating needs of the corporation, rather than to purchase capital assets, is indicative of bona fide indebtedness.” Roth Steel, 800 F.2d at 632. Richard Rowe testified that Indmar always went to a bank for funds to buy capital equipment. He also testified that all of the advances he made to Indmar were used for working capital, as opposed to capital equipment. This is uncontroverted testimony. The government points, however, to Rowe’s testimony that he advanced funds even when Indmar did not “need” the funds, and argues that this somehow cuts against his testimony that the advances were used as working capital. The government’s argument is unpersuasive. We do not find that Rowe’s testimony on this subject was “improbable, unreasonable or questionable,” especially in the absence of the Tax Court addressing this factor in its analysis.5 A review of Indmar’s financial statements shows that it used all of the funds it received in various ways, including working capital and capital equipment expenditures. Thus, Indmar used the advances it received from the Rowes, even if not immediately upon receipt – i.e., Indmar identified a “need” for the advances at some point. There is nothing specific in the record, including Indmar’s financial statements, that suggests the advances went to purchase capital equipment as opposed to being used for working capital. Accordingly, the government’s supposition does not counter Rowe’s testimony, and this factor squarely supports a finding of debt. 6. Sinking Fund “The failure to establish a sinking fund for repayment is evidence that the advances were capital contributions rather than loans.” Id. The Tax Court was correct to point out that the lack of a sinking fund favors equity. This factor does not, however, deserve significant weight under the circumstances. First, a sinking fund (as a type of reserve) is a form of security for debt, and the Tax Court also counted the general absence of security for the stockholder advances as favoring equity. Second, the presence or absence of a sinking fund is an important consideration when looking at advances made to highly leveraged firms. In that case, the risk of repayment will likely be high on any unsecured loans, so any commercially reasonable lender would require a sinking fund or some other form of security for repayment. Where a company has sound capitalization with outside creditors ready to loan it money (as here), there is less need for a sinking fund. See Bordo Prods., 476 F.2d at 1326. 7. The Remaining Roth Steel Factors On the remaining Roth Steel factors, the Tax Court determined that one favored equity (lack of security for the advances) and four favored debt (the company had sufficient external financing available to it; the company was adequately capitalized; the advances were not subordinated to all creditors; and the Rowes did not make the advances in proportion to their respective equity holdings). These findings are well-supported in the record. 5 As the Tax Court did not address this factor, it made no credibility determinations with respect to Richard Rowe’s testimony relating to the use of the advancements. At one point in its decision the Tax Court did find that Rowe’s testimony was “contradictory, inconsistent, and unconvincing” and that the parties “manipulated facts,” but this was in specific reference to its discussion about the inconsistent treatment of the advances as demand debt and long-term debt. See Indmar, 2005 T.C.M. LEXIS 31, at -13; see also supra note 4. No. 05-1573 Indmar Prods. Co. v. Comm’r Page 11 8. Failure to Pay Dividends The Tax Court included in its discussion of Roth Steel a factor not actually cited in that case – Indmar’s failure to pay dividends. In support, the Tax Court cited our decision in Jaques v. Commissioner. The relevance of Jaques to this case is questionable. That case involved the withdrawal of funds by a controlling stockholder from his closely-held corporation. The stockholder argued that the withdrawal itself was a loan. We rejected the argument, relying in part on the fact that the corporation had never issued a formal dividend, and thus the withdrawal could have been a disguised dividend. Jaques, 935 F.2d at 107-08. The situation here is the exact opposite – the stockholders were advancing money to the corporation (not from), and it is the nature of those advances that we must determine. Had the Rowes charged Indmar an exorbitant interest rate, the lack of any formal dividends might have been relevant to showing that the payments were not interest payments, but disguised dividends. As this was not the case, see supra Section II.C.1, we do not address further the relevance, if any, of the lack of dividend payments to the debt/equity question presented here.