MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, JUDGE: These consolidated cases involve the following determinations by respondent of deficiencies in, additions to, and penalties on petitioner's Federal income tax:
Additions to Tax & Penalties
____________________________
Year Deficiency Sec. 6651(a)(1) Sec. 6661 Sec. 6662 Sec. 6663
____ __________ _______________ _________ _________ _________
1987 $ 271,885 $ 48,616 $ 67,971 -- --
1989 217,204 42,824 -- -- $ 162,903
1990 381,883 88,399 -- $ 75,524 --
Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
After concessions, the issues for decision are: (1) Whether petitioner had sufficient basis with respect to an S corporation for his taxable (calendar) years 1987, 1989, and 1990 to permit him to deduct his pro rata share of the corporation's ordinary losses for those years in the amounts of $ 388,106, $ 651,357, and $ 213,732, respectively; and (2) whether (A) the corporation suffered a section 1231 loss from the disposition of property in 1990 and (B) petitioner had sufficient basis to permit him to deduct his pro rata share, $ 1,759,987, of that loss.
FINDINGS OF FACT
Some facts have been stipulated and are so found. The stipulation of facts, with attached exhibits, is incorporated herein by this reference.
At the time the petitions were filed, petitioner resided in Totowa, New Jersey.
WEDGEWOOD ASSOCIATES, INC.
During the years in issue, Wedgewood Associates, Inc., a New Jersey corporation (Wedgewood), was an S corporation, see sec. 1361(a)(1), making its return of income on the basis of a calendar year. Wedgewood was in the restaurant business. In or before 1987, petitioner became a shareholder in Wedgewood. Beginning in 1987 and ending in 1990, petitioner owned the following percentages of Wedgewood's shares:
Year Percentage
____ __________
1987 39.48
1988 52.00
1989 73.00
1990 73.00
Wedgewood was unsuccessful in the restaurant business. It ceased doing business sometime in 1990, and, on or about March 14, 1990, by Deed of Assignment for the Benefit of Creditors (the deed), it conveyed its property for the benefit of those creditors. Attached to the deed is a "Statement of Assets", which lists restaurant fixtures, equipment and furnishings subject to liens of $ 1,865,000, a liquor license, cash on hand, accounts receivable, and liquor inventory. Only the liquor license and liquor inventory are shown to have a value, $ 100,000 and $ 1,000, respectively. 1
CULNEN & HAMILTON, INC.
During the years in issue, Culnen & Hamilton, Inc. (Culnen & Hamilton) was an insurance producer licensed by the State of New Jersey. During those years, petitioner was the sole shareholder of Culnen & Hamilton. Culnen & Hamilton made its return of income on the basis of a fiscal year ending on January 31. From February 1, 1986, through May 31, 1987, Culnen & Hamilton was an S corporation; after May 31, 1987, Culnen & Hamilton was a C corporation. See sec. 1361(a)(2).
WEDGEWOOD'S PAYMENTS
On 46 occasions, from April 1987 through January 1990, Culnen & Hamilton made payments by check and, on one of those occasions, by wire transfer to Wedgewood (without distinction, the 46 checks), in amounts totaling $ 4,034,017.41. 2 The 46 checks were issued to Wedgewood on behalf of petitioner. The payments represented by the 46 checks were shown on the books of Culnen & Hamilton as shareholder loans. The 46 checks were deposited into a bank account of Wedgewood, and their receipt was shown on the books of Wedgewood as indebtedness to petitioner. At some point during the years in issue, there was a reduction of $ 375,000 in the total amount of $ 4,034,017.41 shown on the books of both Wedgewood and Culnen & Hamilton to reflect partial repayments.
On 28 occasions, from April 1989 through March 1992, Culnen & Hamilton issued checks in payment of expenses of Wedgewood's, in amounts totaling $ 501,918.22 (the 28 checks). 3 The payments represented by the 28 checks were shown on the books of Culnen & Hamilton as officer loans and on the books of Wedgewood as indebtedness to petitioner.
On six occasions, from February 1987 through August 1990, Culnen & Hamilton issued checks in payment of, or with respect to, petitioner's purchase from a Dr. Nagel of Dr. Nagel's interest in Wedgewood, in amounts totaling $ 568,152.17 (the six checks). 4 The payments represented by the six checks were shown on the books of Culnen & Hamilton as officer loans.
On eight occasions, from April 1987 through December 1991, Culnen & Hamilton paid certain other amounts, at least some of which related to petitioner's investment in Wedgewood in amounts totaling $ 737,733.27 (the eight payments). 5 The payments represented by the eight payments were shown on the books of Culnen & Hamilton as officer loans.
For 1987 through 1989, Wedgewood recorded on its books interest due to petitioner in the amounts of $ 38,991.08, $ 250,918.44, and $ 326,160.97, respectively (for a total of $ 616,070.49.)
WEDGEWOOD'S INCOME TAX RETURNS
Wedgewood's Federal income tax returns for 1987 through 1990 show the following balance sheet entries with respect to loans from shareholders:
Year Beginning Balance Ending Balance
____ _________________ _______________
1987 $ 186,827 $ 1,773,887
1988 1,773,887 3,530,306
1989 3,530,306 4,380,992
1990 4,380,992 6,097,200
Wedgewood's Federal income tax return for 1990 (the 1990 return) includes a Form 4797, Sale of Business Property, which shows a disposition of furniture and fixtures acquired on April 1, 1988, at a cost of $ 2,780,959, and disposed of on September 1, 1990. There is no gross sales price shown, and a loss is claimed in the amount of $ 2,506,244, which is the acquisition price less depreciation (the difference being Wedgewood's adjusted basis in the property). Taking into account certain other entries on the Form 4797, the net loss reported on that form is $ 2,410,941 (the Form 4797 loss). A Schedule K-1, Shareholder's Share of Income, Credits, Deductions, Etc., accompanying the 1990 return, reports that petitioner's share of the Form 4797 loss is $ 1,759,987.
CULNEN & HAMILTON'S INCOME TAX RETURNS
Culnen & Hamilton's Federal income tax returns for 1987 through 1989 show the following balance sheet entries with respect to loans to stockholders:
____ _________________ ______________
1987 $ 1,814,212 $ 1,712,517
1988 1,712,517 4,329,091
1989 4,329,091 6,702,399
PETITIONER'S INCOME TAX RETURNS
On petitioner's income tax returns for 1987, 1989, and 1990 he claimed the following losses from Wedgewood:
Year Loss
____ _____
1987 $ 388,106
1989 651,357
1990 213,732
On petitioner's 1990 income tax return, he also claimed his share of the Form 4797 loss in the amount of $ 1,759,987 (the $ 1,759,987 loss).
OPINION
I. INTRODUCTIONRespondent disallowed petitioner's pro rata share of Wedgewood's ordinary losses for 1987, 1989, and 1990 because petitioner failed to convince respondent that he had an adequate basis with respect to his investment in Wedgewood. We must determine that basis. Respondent disallowed petitioner's share of the Form 4797 loss (the $ 1,759,987 loss) for the same reason and because petitioner failed to convince respondent that Wedgewood suffered the $ 1,759,987 loss. We must determine both his basis and whether Wedgewood suffered any loss. 6
Petitioner bears the burden of proof. See Rule 142(a).
II. PETITIONER'S BASIS WITH RESPECT TO WEDGEWOODA. PRINCIPAL STATUTORY PROVISIONSSection 1366(a)(1) provides that a shareholder of an S corporation shall take into account his pro rata share of the S corporation's items of income, loss, deduction, or credit for the S corporation's taxable year ending in the shareholder's taxable year. Section 1366(d), however, imposes a limit on the amount of such losses and deductions (without distinction, losses) that a shareholder may take into account for any taxable year. He may not take into account an aggregate amount of such losses exceeding the sum of (1) his adjusted basis in the stock of the S corporation and (2) his adjusted basis in any indebtedness of the S corporation to the shareholder (collectively, his S corporation investment). See sec. 1366(d)(1). Any losses so disallowed may be carried forward indefinitely. See sec. 1366(d)(2).
B. DISAGREEMENT BETWEEN THE PARTIESTo deduct his pro rata share of Wedgewood's losses, petitioner must prove that he had sufficient adjusted basis in his S corporation investment (with respect to Wedgewood, petitioner's Wedgewood investment). Generally, cost defines an S corporation shareholder's initial basis in his S corporation investment acquired for cash. See sec. 1012. Adjusted basis is determined by making certain adjustments to cost basis. See sec. 1016. Section 1367 provides additional, special rules with respect to adjusting basis in an S corporation investment. The disagreement between the parties concerns only petitioner's cost basis in his Wedgewood investment. The parties disagree as to whether petitioner's cost basis in his Wedgewood investment includes the various payments represented by the 46 checks, the 28 checks, the 6 checks, and the 8 payments (collectively, the Wedgewood Payments). Respondent denies that the Wedgewood payments represent petitioner's cost in obtaining his Wedgewood investment. Respondent insists that the Wedgewood payments constitute an investment by Culnen & Hamilton (not petitioner) in Wedgewood. 7 Petitioner insists that the Wedgewood payments represent petitioner's cost in obtaining his Wedgewood investment.
C. PETITIONER'S BURDENTo prevail, petitioner must prove that he, not Culnen & Hamilton, invested in Wedgewood. See, e.g., Prashker v. Commissioner, 59 T.C. 172, 176 (1972) (estate, of which taxpayer was executrix and sole beneficiary, advanced funds to S corporation of which she was 50 percent shareholder: "[T]he key question is whether or not the debt of the corporation runs 'directly to the shareholder.'"). To prove that petitioner invested in Wedgewood, he must prove that the Wedgewood payments created indebtedness on the part of Wedgewood to him. See Bolding v. Commissioner, 117 F.3d 270 (5th Cir. 1997) (true obligor on bank line of credit extended to S corporation was shareholder in his individual capacity and not on behalf of corporation), revg. on another issue T.C. Memo 1995-326; Prashker v. Commissioner, supra at 176 ("a shareholder could borrow the money personally and then loan the money to the corporation. In that event, the corporation's debt would run directly to the shareholder.").
In his brief, respondent heads one of his arguments that petitioner did not have sufficient basis in his Wedgewood investment as follows:
The fact that all payments to Wedgewood Associates, Inc. came
directly from Culnen and Hamilton, precludes petitioner from
claiming those amounts as his basis in Wedgewood and thus, the
Schedule E losses. [Emphasis added.]
If respondent is suggesting that the question of whether Culnen & Hamilton lent those amounts to petitioner is irrelevant since, as a matter of law, direct payments by Culnen & Hamilton to Wedgewood establish Culnen & Hamilton's status as the investor in Wedgewood, he is wrong. In Hitchins v. Commissioner, 103 T.C. 711 (1994), in explaining the statutory requirement that the indebtedness of the S corporation must run directly to the shareholder, we made it clear that an indebtedness to an entity with pass-through characteristics that has advanced the funds to the S corporation and is closely related to the taxpayer does not satisfy the statutory requirement. See id. at 715. We did not say, however, that the fact that the borrowed funds originate with the closely related entity precludes the indebtedness of the S corporation from running directly to the shareholder. Certainly, where there is a close relationship among the S corporation, the taxpayer, and the related entity, we will scrutinize the relationships established with respect to the transfer of funds to ensure that those relationships comport with the statutory requirement. Respondent proposes Underwood v. Commissioner, 63 T.C. 468 (1975), affd. 535 F.2d 309 (5th Cir. 1976), as a model for us to follow in this case. In Underwood, the taxpayer's S corporation was indebted to a second corporation owned by him. The taxpayer interposed himself between the two corporations by causing the corporations to substitute for the one-legged indebtedness running between the S corporation and the second corporation a two-legged indebtedness, running, first, from the S corporation to him and, second, from him to the second corporation. We concluded that the taxpayer had paid out no funds and would not until his note to the second corporation came due. On that basis, we were unable to distinguish his liability from that of a guarantor, who makes no investment until he pays his obligation. See 63 T.C. at 475-476. We relied on a long list of cases for the proposition (which we applied to the taxpayer) "that basis-giving indebtedness for the purposes of section 1374(c)(2)(B) does not arise where a shareholder merely guarantees a subchapter S corporation's debt". 8Id. at 475. That is true, but that is not the case here.
D. DISCUSSION1. PETITIONER'S CASE
Petitioner called four witnesses, including himself, all of whom testified consistently that, for many years (including the years in question), petitioner had used Culnen & Hamilton as an incorporated pocketbook, having the corporation make payments on his behalf, which payments were posted to Culnen & Hamilton's books as loans to petitioner. Robert Levin, one of those four witnesses, had been petitioner's accountant for more than 20 years. He also did accounting work for Culnen & Hamilton. He testified that, from time to time, petitioner would reduce the balance of his Culnen & Hamilton loan account by liquidating investments he had made and paying the proceeds to Culnen & Hamilton. Mr. Levin explained the rationale for that procedure as follows:
Culnen & Hamilton was an "S" corporation. There was a lot
of undistributed taxable income. He [petitioner] wouldn't take
all the -- he'd pay taxes on it, and, God knows, he paid a lot
of taxes over the years, but he felt the money that was left in
Culnen & Hamilton, because it was undistributed to him, that he
could spend and do what he wanted with.
So, rather than write a check to himself and write a check
to a third party, he would just -- if he wanted to buy a company
or whatever, he would just write it out -- have Beatrice, the
bookkeeper, write it out of Culnen & Hamilton, charge it to his
loan account, okay, and that's the way he did business for the
20 years that I've been his accountant.
Although Culnen & Hamilton was an S corporation only until May 31, 1987, Mr. Levin's testimony presents a credible explanation of petitioner's relationship with Culnen & Hamilton.
Janet Sacklow is a partner in the accounting firm of Amsterdam, Sacklow & Acox. That firm also did accounting work for Culnen & Hamilton, including preparing various financial records and its income tax returns for the years in question. Ms. Sacklow testified that she treated the Wedgewood payments as loans to petitioner for purposes of both Culnen & Hamilton's books and records and its income tax returns. She testified that the initial record of the Wedgewood payments was made by Culnen & Hamilton's bookkeeper, Beatrice, who would record the Wedgewood payments on the corporation's general ledger under the heading "Wedgewood" (the Wedgewood entries). Beatrice made the Wedgewood entries monthly. Ms. Sacklow testified that she was responsible for classifying the Wedgewood entries as loans to petitioner. She testified that she made that determination based on conversations with petitioner and because she believed that Culnen & Hamilton had no association with Wedgewood: "It was only because of Dan Culnen that the money was coming from that location [i.e., from Culnen & Hamilton]." The parties have stipulated a letter dated February 11, 1993, from Ms. Sacklow to Walter J. Pagano, c.P.A. (the Sacklow letter). 9 The Sacklow letter states: "Enclosed are the schedules of amounts loaned to Wedgewood Associates and Dan's acquisition costs for stock and partnership interests." Ms. Sacklow testified that she prepared those schedules (the schedules) from the books and records of Culnen & Hamilton. The first of the schedules relates to the 46 checks and states that they were "deposited into Wedgewood Associates accounts, on behalf of Daniel Culnen." The third of the schedules relates to the six checks and states: "Daniel Culnen's purchase of Dr. Nagle's Interest". The final page of the schedules states:
Summary
Net Checks Written to Wedgewood from
Culnen and Hamilton $ 3,659,017.41
Checks written from Culnen and
Hamilton on behalf of Wedgewood 501,918.22
Dan's purchase of Dr. Nagle's interest 568,152.17
Other Items 737,733.27
Interest Accrued 616,070.49
_____________
Total $ 6,082,891.56
=============
Of this total, $ 300,000 is classified as Capital Stock in
Wedgewood Associates, and $ 300,000 is Dan's cost of
purchasing Manning's partnership interest. $ 568,152.17 is Dan's
cost for Nagle's interest in stock and partnership. This leaves
a balance of $ 4,914,739.39 as a loan to the corporation.
Ms. Sacklow's firm also did accounting work for Wedgewood. She would assist Wedgewood's employees in keeping Wedgewood's books and would prepare Wedgewood's end-of-the-year tax returns. She testified that the Wedgewood payments were shown as an indebtedness from Wedgewood to petitioner on Wedgewood's books and records. Mr. Levin, who prepared petitioner's personal financial statements, which showed Wedgewood as an investment of petitioner's, believed "absolutely" that petitioner owned the shares of Wedgewood individually.
2. RESPONDENT'S CASE
Respondent called no witnesses and introduced no exhibits other than those attached to the stipulation. Besides respondent's argument (which we have rejected) that, because of the Wedgewood payments, petitioner is precluded from claiming basis in his Wedgewood investment, respondent's other argument is, basically, that the testimony of petitioner and his witnesses is unsupported and, thus, not to be believed.
Petitioner, Mr. Levin, and Ms. Sacklow (the witnesses) all testified that the Wedgewood payments were made by Culnen & Hamilton to Wedgewood on petitioner's behalf. The fact that the payments were made is beyond question. Indeed, during the trial, the Court asked counsel for respondent: "Mr. Ianacone, is it a fact for purposes of this case that those checks [the 46 checks] * * * were written by Culnen & Hamilton and deposited for the benefit of Mr. Culnen into the accounts of Wedgewood? Is that a fact: Yes or no?" Mr. Ianacone responded: "Yes, it is." Thus, the only question subject to proof is whether the Wedgewood payments were made by Culnen & Hamilton on behalf of petitioner. While it is true that there are no original Culnen & Hamilton accounting records in evidence (other than copies of its tax returns), the Sacklow letter is in evidence, and it supports the testimony of the witnesses. Ms. Sacklow testified that she prepared the Sacklow letter from the books and records of Culnen & Hamilton, and she traced the treatment of the Wedgewood payments from the bookkeeper's scheduling of them through her (Ms. Sacklow's) classification of them as loans to petitioner, to their entry onto the books and records of Culnen & Hamilton. 10 While respondent may claim that the Sacklow letter is not a substitute for the original books and records of Culnen & Hamilton, respondent cannot claim that petitioner has presented no evidence to support the witnesses' testimony. The Sacklow letter is such evidence, and, moreover, the Sacklow letter is a joint exhibit. Respondent may also claim that he did not know what Ms. Sacklow would say about the Sacklow letter, but he could have discovered that before he agreed to make it a joint exhibit. Since respondent stipulated the Sacklow letter (waiving any hearsay objection), we believe that petitioner justifiably concluded that the content of Culnen & Hamilton's books was not an issue in this case. Respondent's claim that, essentially, the witnesses' testimony should be disregarded because it is unsupported is not persuasive.
Beyond respondent's claim that petitioner's witnesses' testimony is unsupported, respondent makes unsupported, unpersuasive, and offensive attacks on the credibility of petitioner and the ethics of his witnesses. There are legitimate issues in this case, but the ethics of petitioner's witnesses are not among them. Respondent has, here, all too clearly relied on the tactic of trial by cross- examination, and that tactic has failed. A resort to name-calling is not an acceptable fallback position. We disapprove of that tactic.
E. CONCLUSIONSWe conclude, and find, that petitioner had adequate adjusted basis in his Wedgewood investment to deduct his pro rata share of Wedgewood's losses for 1987, 1989, and 1990 and his share of the Form 4797 loss (if any). 11
III. THE FORM 4797 LOSSA. INTRODUCTIONPetitioner reported his share of the Form 4797 loss, in the amount of $ 1,759,987. Principally, the Form 4797 loss resulted from Wedgewood's disposition of furniture, fixtures, restaurant equipment, a liquor license, and a liquor inventory (the assets). The assets were disposed of pursuant to the deed. At least some of the assets were subject to liens of secured creditors totaling $ 1,865,000 (the liens). Wedgewood's adjusted basis in the assets at the time of disposition was $ 2,506,244. Pursuant to the deed, Wedgewood received nominal consideration of $ 1, and the disposition was part of a bankruptcy-like proceeding carried out under the laws of New Jersey. See N.J. Stat. Ann. secs. 2A:19-1 to 2A:19-50 (West 1987). The disposition was to an assignee for the benefit of Wedgewood's creditors (the assignee), whose duty it was to liquidate the assets and apply the proceeds to reduce Wedgewood's indebtedness. See In re: Gen. Assignment for Benefit of Creditors, 66 N.J. Super. 423, 169 A.2d 236 (N.J. Super. Ct. 1961).
B. CODE AND REGULATIONSIn pertinent part, section 1001(a) provides that the loss from the disposition of property shall be the excess of the adjusted basis in the property over the amount realized. As used in section 1001(a), the term "amount realized" is defined in section 1001(b). In pertinent part, that definition is: "The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. " Section 1.1001-2, Income Tax Regs., addresses the discharge of liabilities in connection with the disposition of property. Paragraph (a)(1) of section 1.1001-2, Income Tax Regs., provides the general rule that the amount realized from the sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the disposition. Paragraph (a)(4) of section 1.1001-2, Income Tax Regs., provides that, for purposes of that section, the sale or other disposition of property that secures a nonrecourse liability discharges that liability. Paragraph (b) of section 1.1001-2, Income Tax Regs., provides that, generally, the fair market value of the security at the time of sale is not relevant for determining the amount of liabilities from which the taxpayer is discharged, or treated as discharged.
C. DISCUSSIONRespondent's position is that Wedgewood did not realize any loss. Petitioner's position is that, since Wedgewood's adjusted basis in the assets exceeded the $ 1 received pursuant to the deed, of course it suffered a loss. Petitioner has failed to prove that $ 1 was the full amount realized on the disposition of the assets. On brief, petitioner states: "Wedgewood's liabilities greatly exceeded the fair market value of its assets." That may be so. Nevertheless, petitioner has failed to show that the indebtedness secured by the liens was other than nonrecourse. If it was nonrecourse, then, notwithstanding the fair market value of the assets subject to those liens, the amount realized on the disposition of those assets included the amount of the liens, $ 1,865,000. We assume that the liquor license and liquor inventory were sold for $ 126,000. 12 Petitioner has failed to argue that the amount realized by Wedgewood does not include any actual cash proceeds from the sale of assets not subject to liens. Thus, the amount realized on the disposition of the assets was $ 1,991,001, which is the sum of the indebtedness discharged, the cash proceeds of $ 126,000, and the nominal cash of $ 1. Since Wedgewood's adjusted basis in the assets was $ 2,506,244, Wedgewood's loss was $ 515,243 ($ 515,243 = $ 2,506,244 -- 1,991,001).
D. CONCLUSIONWe find that Wedgewood realized a loss of $ 515,243 on the disposition of the assets. Petitioner's pro rata share of that loss was $ 376,127 (i.e., 73 percent of $ 515,243). We have already found in section II.E., supra, that petitioner had sufficient basis to deduct his pro rata share of the Form 4797 loss, $ 376,172.
Decisions will be entered under Rule 155.