                         T.C. Memo. 2017-1



                  UNITED STATES TAX COURT



  JOHN M. SENSENIG AND ALTA Z. SENSENIG, Petitioners v.
    COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 16254-11.                         Filed January 3, 2017.



       P-H was the sole shareholder and president of CLCL, an
S corporation. CLCL provided high-risk capital to various
companies, including G-L, LFP, and WSC. P-H also owned an equity
interest in each of G-L, LFP, and WSC. No loan documents were
created for the advances to the three corporations; P-H did not
undertake “due diligence” analysis of borrowers that a typical creditor
would have undertaken; CLCL made the advances notwithstanding
WSC’s other superior creditors; and P-H never attempted to collect
repayment of the advances. P-H claimed a bad debt deduction for
CLCL on CLCL’s Form 1120S, “U.S. Income Tax Return for an S
Corporation”, for 2005. The Form 1120S did not identify the source
of the deduction; but during R’s examination, P-H stated it was for
alleged loans to G-L and LFP. In this litigation Ps alleged that the
bad debts arose from loans to WSC rather than to G-L and LFP.

      Held: The advances by P-H through CLCL were not loans but
investments in equity, and they did not become worthless in 2005.
Therefore Ps are not entitled to a business bad debt deduction for
2005.
                                           -2-

[*2]         Held, further, Ps are liable for an accuracy-related penalty
       under I.R.C. sec. 6662(a).



       John M. Sensenig and Alta Z. Sensenig, for themselves.

       Kristina L. Rico, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


       GUSTAFSON, Judge: Pursuant to section 6212(a),1 the Internal Revenue

Service (“IRS”) determined deficiencies in the 2003, 2004, and 2005 income tax

of petitioners, John M. Sensenig and Alta Z. Sensenig, as well as accuracy-related

penalties under section 6662(a) for all three years and an addition to tax under

section 6651(a)(1) for 2003. The Sensenigs filed a timely petition under section

6213(a) which stated that they “appeal the IRS findings”. We construe this pro se

petition to request, for all three years, redetermination of the tax, penalties, and

(for 2003) the addition to tax. At the time they filed the petition, they resided in

Pennsylvania.


       1
        Unless otherwise indicated, all section references are to the Internal
Revenue Code (26 U.S.C.), as amended, and all Rule references are to the Tax
Court Rules of Practice and Procedure. All amounts are rounded to the nearest
dollar.
                                          -3-

[*3] After concessions by the parties,2 the issues to be decided are: (1) whether

the Sensenigs are entitled to a business bad debt deduction of $10,695,581 for

2005 (we hold that they are not); and (2) whether the Sensenigs are liable for the

accuracy-related penalty for 2005 (we hold that they are).

                                FINDINGS OF FACT

I.    Mr. and Mrs. Sensenig

      Mr. Sensenig is an entrepreneur and a self-taught licensed public

accountant, and Mrs. Sensenig is a homemaker. Mr. Sensenig has prepared tax

returns since 1972, received his license in December 1978, and maintained his

license into the 1990s. Mr. Sensenig owns his own tax return preparation

business, Group Support, Inc., an S corporation. At one time Mr. Sensenig

prepared approximately 300 personal and business Federal tax returns a year,

      2
        In September 2014 the parties filed a “Stipulation of Settled Issues” that
addresses certain adjustments in the notice of deficiency and concludes (in
paragraph 10): “The remaining items at issue in this case are whether petitioner is
entitled to the claimed Schedule E bad debt in the amount of $10,695,581 claimed
in taxable year 2005 and whether the addition to tax under I.R.C. § 6662 apply.”
Paragraph 5 of the “First Stipulation of Facts” filed at trial in June 2015 states that
“[t]he parties entered into a stipulation of settled issues that resolved all of the
issues for the taxable years 2003 and 2004.” In view of respondent’s burden of
production under section 7491(c), and in view of the silence of both respondent’s
pretrial memorandum and his post-trial brief on the penalty issue for 2003 and
2004 and the addition to tax under section 6651(a)(1), we construe the stipulation
to resolve in the Sensenigs’ favor the penalties for 2003 and 2004 and the addition
to tax for 2003.
                                         -4-

[*4] including all of his own Federal income tax returns as well as all the Federal

tax returns for the companies in which he had an equity interest.

II.    Conestoga Log Cabin Leasing, Inc.

       Over the last 30 years, Mr. Sensenig has had an equity interest in a number

of companies, including S corporations named Conestoga Log Cabins and

Conestoga Log Cabins Leasing, Inc. (“CLCL”). Mr. Sensenig served as president

of CLCL; and by 2005 he was its sole owner and the sole signatory of its bank

accounts. Conestoga Log Cabins was in the business of selling log cabin kits and

log home kits. CLCL was first organized as a manufacturer of the log cabin kits

sold by Conestoga Log Cabins, but CLCL later provided financing to buyers who

could not afford to pay for the kits outright. The funds used to finance these

purchases came from Mr. Sensenig’s investor pool.

III.   Investor pool

       Mr. Sensenig solicited investments in the CLCL financing activity by other

Mennonite and Amish individuals. The investors were promised attractive rates of

return by demand notes payable by Mr. Sensenig individually or by CLCL. The

notes bore interest rates but no maturity dates. Initially these invested funds were

used only to finance log cabin purchases; but because numerous Amish and

Mennonite investors became interested in investing funds with Mr. Sensenig, he
                                         -5-

[*5] began accepting additional funds (and executing demand notes with favorable

interest rates) to invest in other companies.

      Mr. Sensenig, through CLCL, advanced money to start-up companies and to

companies already in existence that had an opportunity for a new product or line

of business. Mr. Sensenig never reviewed formal written projections for the

companies that CLCL invested in. Mr. Sensenig did not obtain any third-party

audits or request any financial statements, and CLCL did not finance any company

if that company had other means to borrow, such as traditional banking.

Mr. Sensenig stated that he relied on “gut feel” as to when something made

financial sense and preferred being able to “turn on a dime”; and he acknowledged

at trial that CLCL provided “high-risk capital” and that it was “an investment

business”.

      In return for the money CLCL advanced, Mr. Sensenig acquired an equity

interest in the company (apparently a minority interest in most or all cases); and

Mr. Sensenig acquired financial control over each of the companies that CLCL

invested in by becoming a director, a bank account signatory, and the chief

financial officer. Thereafter he prepared the tax returns for the company.

      Repayment of amounts advanced by CLCL to a company was not

anticipated until the project had been “completed”, unless there was a surplus
                                        -6-

[*6] (which CLCL never had). CLCL and Mr. Sensenig never charged a

commission or fee for services to any of the invested-in companies.

      Mr. Sensenig eventually raised investments totaling in excess of $50 million

from numerous investors, primarily through a small advertisement in a

Pennsylvania Dutch newspaper.

      Mr. Sensenig maintained detailed account records for each investor, sent the

investors quarterly statements reporting interest accrued, and issued to them

Forms 1099. The investors did not have a say in where Mr. Sensenig or CLCL

invested their money, and there was no formal approval or voting process as to

what companies or projects Mr. Sensenig or CLCL chose for investment.

IV.   2005 Investments

      In 2005 Mr. Sensenig, through CLCL, invested in 15-20 different

companies. Three of these are relevant to the parties’ dispute about the Sensenigs’

claim of a 2005 bad debt loss:

      A.    Glue-Lam, Inc.

      Glue-Lam, Inc. (“G-L”), was organized in 1999 as a C corporation to design

and manufacture glue-laminated timber. As late as 2005, G-L’s lamination

process was still under development, and the product was never manufactured.

Mr. Sensenig had an equity interest in G-L, and during taxable years 2003 through
                                        -7-

[*7] 2005, CLCL advanced approximately $1,481,000 to G-L. The other

shareholders of G-L contributed one dollar each to G-L’s capital.

      Mr. Sensenig was appointed a director, the chief financial officer, the

bookkeeper, and the paymaster of G-L, and he was made a signatory of G-L’s

accounts. Mr. Sensenig never received a salary. Mr. Sensenig stipulated that his

goal for his investment in G-L was to profit from his ownership interest.

      Although the records of CLCL included journal entries labeling some of

CLCL’s advances to G-L as “loans”, neither Mr. Sensenig nor CLCL executed any

notes, agreements, or other documents with G-L evidencing any loan. According

to its tax returns, G-L continued to acquire assets through 2005.

      Mr. Sensenig has not provided any evidence that CLCL ever held G-L in

default, and Mr. Sensenig admits he never demanded repayment of these advances

from G-L. Mr. Sensenig did not take legal action against G-L because of his

status as a shareholder as well as his Mennonite religious views. There is no

documentary evidence that CLCL wrote off any portion of the G-L debts on its

books in 2005. Mr. Sensenig stated that the only evidence would be on the tax

returns themselves.

      G-L was still operating after 2005 (the year of the claimed bad debt loss),

and for several years CLCL continued to advance money to G-L. The records
                                        -8-

[*8] reflect that in 2006 CLCL advanced $800,000, that in 2007 CLCL advanced

another $950,000, and that in 2008 CLCL advanced an additional $1 million.

Some portion (which we cannot quantify) of the funds advanced in those years

reflects an increase in amounts of interest that G-L owed to CLCL, which CLCL

accrued but which G-L did not pay.

       As late as June 2010, G-L had an active Web site. G-L’s final Federal

income tax return was filed for taxable year 2011. As late as May 2015, G-L was

listed as “Active” on the Pennsylvania Department of State Web site.

       B.    Lebanon Finished Products

       Lebanon Finished Products (“LFP”) was organized in 2001 as an

S corporation and was in the business of polishing rebar. CLCL purchased equity

in LFP because Mr. Sensenig thought one of its employees had a good idea for

constructing a machine to “electro polish.” Since LFP did not have sufficient

capital to develop the product, Mr. Sensenig purchased a 33% equity interest in

LFP. During taxable years 2003 through 2005, CLCL advanced $1,476,000 to

LFP.

       No further equity contributions were made by anyone else. Mr. Sensenig

was appointed a director, the chief financial officer, the bookkeeper, and the

paymaster of LFP, and he was made a signatory of LFP’s accounts. Mr. Sensenig
                                        -9-

[*9] did not receive a salary from LFP, and his stated goal for CLCL’s investment

in LFP was to profit from its ownership interest.

      Neither Mr. Sensenig nor CLCL executed with LFP any documentation

evidencing any loan. As with G-L, Mr. Sensenig did create, on CLCL’s records,

journal entries that labeled some of the advances from CLCL to LFP as “loans”.

      According to its tax returns, LFP continued to acquire assets through 2005.

      Mr. Sensenig has not provided any evidence that CLCL held LFP in default,

and Mr. Sensenig never demanded repayment of these advances from LFP. Mr.

Sensenig did not take legal action against LFP because of his status as shareholder

of LFP, as well as his religious views. There is no documentary evidence that

CLCL wrote off any portion of the LFP debts in 2005 on its books. After 2005

LFP was still operating.

      The record reflects that in 2006 (the year after the claimed bad debt loss)

CLCL advanced approximately $1.2 million to LFP, of which approximately

$700,000 represented accrued but unpaid interest. During 2007 CLCL continued

to finance LFP because Mr. Sensenig hoped that LFP could obtain a patent. As

late as May 2007 LFP had an active Web site, and as late as May 2015 LFP was

listed as “active” on the Pennsylvania Department of State Web site.
                                       -10-

[*10] C.    Washington Street Castings

      Washington Street Castings (“WSC”) was organized in 2001 as an

S corporation and operated a foundry on a large plot of land that Mr. Sensenig

considered ideal for development. WSC had financed its land acquisition by

obtaining loans from unrelated third-party sources, and Mr. Sensenig

acknowledged that these lenders had a claim to that property superior to CLCL’s

claim. At some point after WSC’s land acquisition, Mr. Sensenig through CLCL

bought a 25% equity interest in WSC. WSC continued operating the existing

foundry.

      In December 2003 the shareholders of WSC entered into an “Authorizing

Resolution”, by which the president of WSC was authorized to borrow money or

obtain extensions of credit from CLCL. According to the resolution, the president

of WSC was authorized “to execute all documents, instruments and agreements as

may be required by the Lender [CLCL] to fulfill the conditions of any loan

agreement, note, mortgage or other financing document”, but no such documents

were ever executed.

      During taxable years 2003 through 2005, CLCL advanced $2,031,500 to

WSC. Mr. Sensenig was appointed a director, the chief financial officer, the

bookkeeper, and the paymaster of WSC, and he was made a signatory of the
                                        -11-

[*11] company’s accounts. Mr. Sensenig did not receive a salary from WSC.

Mr. Sensenig’s stated goal for his investment in WSC was to profit from his

ownership interest.

      As with G-L and LFP, Mr. Sensenig did create on the records of CLCL

journal entries that labeled some of the advances from CLCL to WSC as “loans”.

CLCL did not hold WSC in default, and Mr. Sensenig has never made formal

demands for repayment from WSC. Mr. Sensenig asserts that because he was an

insider wearing several hats, no formal demands were necessary. Mr. Sensenig

did not take legal action against WSC because of his status as a shareholder of

both companies as well as his religious beliefs.

      There is no documentary evidence that CLCL wrote off any portion of the

WSC debts on its books in 2005. After 2005 WSC was still in operation. In 2006

CLCL advanced an additional $1.4 million to WSC, of which approximately

$44,000 represented accrued but unpaid interest; and again in 2007 CLCL

advanced approximately $1.1 million to WSC. As late as May 2015, WSC was

listed as “Active” on the Pennsylvania Department of State Web site.

V.    Investigation by securities regulators

      The Pennsylvania Securities Commission (“PSC”) investigated

Mr. Sensenig’s receipt of funds borrowed from his investors. The PSC determined
                                        -12-

[*12] that Mr. Sensenig’s practice of issuing demand notes to investors in return

for receipt of borrowed funds constituted the sale of unregistered securities. In

June 2005 Mr. Sensenig and CLCL received from the PSC an order to cease and

desist the offering and sale of unregistered securities. As a result, Mr. Sensenig

was barred from accepting any more money into the investor pool, and he lacked

funds to advance to the not-yet-completed projects from which he had expected

eventually to pay off the demand notes. He perceived this as a dire threat to

CLCL, its investors, and its investments.

      In January 2006 the PSC accepted Mr. Sensenig’s offer of settlement and

rescinded the summary order to cease and desist. Mr. Sensenig and CLCL were

permanently barred from offering or selling securities in Pennsylvania unless he

received a valid registration statement. Thereafter, Mr. Sensenig took steps to try

to register with the U.S. Securities and Exchange Commission, but it proved too

costly and he abandoned the effort.

VI.   The 2005 tax returns

      In 2006 Carl Smith, a certified public accountant (“C.P.A.”) employed by

Group Support, Inc., prepared CLCL’s 2005 Form 1120S, “U.S. Income Tax

Return for an S Corporation”. While doing so, he recommended that CLCL

deduct $10,695,581 as bad debt. The Form 1120S does not identify the source of
                                        -13-

[*13] the bad debt deduction; but according to CLCL’s general ledger for January

1 through December 31, 2005, the total bad debt as of December 31, 2005, was

$10,695,581, which included $4,917,529 attributable to G-L and $5,150,533

attributable to LFP. Mr. Sensenig followed this recommendation because he and

Mr. Smith believed the possibility either company would become profitable was

remote. Mr. Sensenig signed the 2005 CLCL Form 1120S that Mr. Smith

prepared. Apart from the bad debt deduction, CLCL would have reported ordinary

business income for 2005 in the amount of $2,741,526; but instead CLCL’s

Form 1120S reported a net loss, after the bad debt deduction, of $7,954,055.

      Mr. and Mrs. Sensenig filed their 2005 Form 1040, “U.S. Individual Income

Tax Return”, on October 16, 2006. For reasons the record does not show, they did

not claim on their return any portion of CLCL’s reported loss.

VII. The Commissioner’s examination

      The IRS examined CLCL’s and the Sensenigs’ tax returns for 2003 through

2005. On May 8, 2007, the Commissioner’s revenue agent toured G-L and LFP;

both companies were still in existence at that time, but only LFP was still

operating at the time of the facility tour. On May 24, 2007, the IRS requested

documents and information from Mr. Sensenig regarding the bad debt deduction

claimed for G-L and LFP. Two days later, Mr. Smith met with the revenue agent
                                        -14-

[*14] to discuss the IRS’s information document request (“IDR”), and at the

meeting Mr. Sensenig provided the agent with a one-page written explanation of

the “2005 Bad Debt Write Offs”. That document stated that the loans for which

CLCL claimed a bad debt deduction were to G-L and LFP. During Mr. Sensenig’s

examination, no companies other than G-L and WSC were mentioned as having

deductible bad debts.

      On June 21, 2007, the IRS again requested information and documents

regarding the claimed bad debt deduction attributable to G-L and LFP, but no

documentary information was provided in response to the request. Mr. Sensenig

did not provide the IRS with any documentary evidence of the interest rate.

      The examination continued, and in 2009 Mr. Sensenig agreed with the IRS

that the bad debt deduction was erroneous. Mr. Sensenig said he had been

unaware that the bad debt deduction was claimed on CLCL’s 2005 return and

agreed that it should not have been. (Now, however, Mr. Sensenig maintains that

the decision made in 2005 to claim the bad debt deduction was correct because the

events that triggered the loss (chiefly, the cease-and-desist order) occurred in

2005.)

      The IRS sent Mr. and Mrs. Sensenig a statutory notice of deficiency

(“NOD”) on May 13, 2011. For 2005 the NOD disallowed CLCL’s bad debt
                                        -15-

[*15] deduction, attributed the resulting income to the Sensenigs, and determined

the resulting deficiency in tax (along with an accuracy-related penalty under

section 6662(a)).

VIII. Tax Court litigation

      After receiving the NOD, the Sensenigs timely filed with the Tax Court in

July 2011 a petition for redetermination of the deficiency, the addition to tax, and

the penalties in the notice. When preparing the petition, Mr. Sensenig concluded

that CLCL should have deducted in 2005 an additional bad debt, arising not from

G-L and LFP but from WSC.

      At trial the Court asked Mr. Sensenig to offer into evidence financial

information regarding the companies at issue to show that they could not pay the

debts to CLCL. Mr. Sensenig said the only evidence he could provide was

“common sense evidence”. That is, he maintains, because the securities regulators

shut down his investment activity with the June 2005 cease-and-desist order, he

lacked additional funds with which he could keep the companies going, and it was

obvious that the companies were therefore doomed and that CLCL’s alleged loans

to them became worthless.
                                         -16-

[*16] IX.    Ultimate findings of fact

      We find that CLCL’s advances to G-L, LFP, and WSC were not loans and

that, if they were, they did not become worthless in 2005.

                                     OPINION

      The primary issue for decision is whether the Sensenigs are entitled to a

business bad debt deduction for 2005 under section 166(a). The secondary issue is

whether the Sensenigs are liable for the accuracy-related penalty under section

6662(a) for 2005.

I.    Burden of proof

      The IRS’s determinations are presumed correct; and taxpayers generally

bear the burden to prove their entitlement to any deduction they claim, Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933), and they must satisfy the

specific requirements for any deduction they claim, INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992). To that end, taxpayers must substantiate

each claimed deduction by maintaining records sufficient to establish the amount

of the deduction and to enable the Commissioner to determine the correct tax

liability. Sec. 6001; Higbee v. Commissioner, 116 T.C. 438, 440 (2001).

Specifically, in this case, “[t]he burden of proving the reality of * * * indebtedness
                                         -17-

[*17] rests on the petitioner.” P.M. Fin. Corp. v. Commissioner, 302 F.2d 786,

789 (3d Cir. 1962), aff’g T.C. Memo. 1961-108.

      The Court need not accept a taxpayer’s self-serving testimony when the

taxpayer fails to present corroborating evidence. Beam v. Commissioner, T.C.

Memo. 1990-304 (citing Tokarski v. Commissioner, 87 T.C. 74, 77 (1986)), aff’d

without published opinion, 956 F.2d 1166 (9th Cir. 1992).

      With respect to an individual taxpayer’s liability for penalties and additions

to tax, section 7491(c) places the burden of production on the Commissioner.

II.   Bona fide debt deduction

      A.     General principles

      A taxpayer is entitled to a deduction for any bona fide debt that becomes

worthless within the taxable year. See sec. 166(a)(1); 26 C.F.R. sec. 1.166-1(c),

Income Tax Regs. To be able to deduct the reported bad debt for 2005, Mr.

Sensenig must show: (1) that the advances made to G-L, LFP, or WSC were debt

(not equity); (2) that the debt became worthless3 in taxable year 2005; and (3) that

      3
        The Sensenigs did not assert entitlement to a deduction for partially
worthless bad debt under section 166(a)(2) in their petition or at trial. The
regulations provide that a partially worthless bad debt may be deducted only to the
extent that the debt is charged off during the taxable year, see 26 C.F.R. sec.
1.166-3(a)(2), Income Tax Regs., but the Sensenigs presented no evidence that
CLCL “charged off” any portion of the purported debt owed by WSC, G-L, or LFP
                                                                         (continued...)
                                        -18-

[*18] the debt was incurred not as an investment but in connection with a trade or

business (i.e., the business of promoting, organizing, and financing or selling

corporations). Because we conclude that Mr. Sensenig failed to prove the first and

second of these characteristics, see infra parts II.B and II.C, we need not and do

not reach the third.4

      B.     Debt vs. equity

      A bona fide debt arises from “a debtor-creditor relationship based on a valid

and enforceable obligation to pay a fixed or determinable sum of money.” Kean v.

Commissioner, 91 T.C. 575, 594 (1988); 26 C.F.R. sec. 1.166-1(c), Income Tax


      3
        (...continued)
to CLCL in 2005. For these reasons, and because the Sensenigs failed to prove
that the transfers from CLCL to WSC, G-L, or LFP were loans, we do not further
address section 166(a)(2).
      4
        If CLCL made its advances as an investor and not in the course of a trade
or business, see Whipple v. Commissioner, 373 U.S. 193 (1963), then loans it
made might yield nonbusiness bad debt. Section 166(d) provides that taxpayers
other than corporations may deduct “nonbusiness” bad debts only when they
become worthless and then only as short-term capital losses. See sec. 166(d)(1).
The Commissioner takes the position that section 166(d) limits an individual
taxpayer’s deduction of nonbusiness bad debts passed to him through an
S corporation (even though the S corporation is a corporation). See Rev. Rul.
93-36, 1993-1 C.B. 187. For the Sensenigs, a short-term capital loss deduction
would evidently be limited to $3,000. See sec. 1211(b). Because we determine
that CLCL’s interests in G-L, LFP, and WSC were not debt and were not
worthless, we need not and do not decide the issue of whether (if they had been
debt) they would have been nonbusiness debt and whether section 166(d) would
apply to limit the deduction.
                                           -19-

[*19] Regs. By definition, a capital contribution is not a debt for purposes of

section 166. See 26 C.F.R. sec. 1.166-1(c). The question now before us is

whether Mr. Sensenig proved that CLCL’s advances to G-L, LFP, and WSC were

loans (giving rise to debts) or instead were equity investments.

               1.     Frequent complexities

      As we will later show, this case is simpler than some debt-vs.-equity cases,

but to put this case in context, we describe the field generally. Section 385

addresses the classification of whether an interest in a corporation is debt or

equity. The statute authorizes the Secretary to prescribe regulations5 setting forth

factors to be taken into account in resolving the issue, and it provides five factors

that “the regulations may include”, sec. 385(b) (emphasis added), the first of

which is “a written unconditional promise to pay on demand or on a specified date

a sum certain in money in return for an adequate consideration in money or

money’s worth, and to pay a fixed rate of interest”,6 sec. 385(b)(1).


      5
       The Secretary promulgated final regulations under section 385 in October
2016, but those regulations do not apply to the tax years in issue in this case. See
81 Fed. Reg. 72858 (Oct. 21, 2016).
      6
          The other four of the five factors are:

      (2) whether there is subordination to or preference over any
      indebtedness of the corporation,
                                                                        (continued...)
                                        -20-

[*20] In Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968),

the U.S. Court of Appeals for the Third Circuit, to which a decision in this case

will apparently be appealable, enumerated 16 “criteria by which to judge the true

nature of an investment which is in form a debt”:

      (1) the intent of the parties; (2) the identity between creditors and
      shareholders; (3) the extent of participation in management by the
      holder of the instrument; (4) the ability of the corporation to obtain
      funds from outside sources; (5) the “thinness” of the capital structure
      in relation to debt; (6) the risk involved; (7) the formal indicia of the
      arrangement; (8) the relative position of the obligees as to other
      creditors regarding the payment of interest and principal; (9) the
      voting power of the holder of the instrument; (10) the provision of a
      fixed rate of interest; (11) a contingency on the obligation to repay;
      (12) the source of the interest payments; (13) the presence or absence
      of a fixed maturity date; (14) a provision for redemption by the
      corporation; (15) a provision for redemption at the option of the
      holder; and (16) the timing of the advance with reference to the
      organization of the corporation.

Id.; see also Scriptomatic, Inc v. United States, 555 F.2d 364, 368 (3d Cir. 1977)

(noting that the weight of precedent in the realm of debt-equity determination

flows from the framework of analysis on the basis of the factors enumerated in Fin

      6
       (...continued)
      (3) the ratio of debt to equity of the corporation,
      (4) whether there is convertibility into the stock of the corporation,
      and
      (5) the relationship between holdings of stock in the corporation and
      holdings of the interest in question.

Sec. 385(b).
                                          -21-

[*21] Hay); Trans-Atl. Co. v. Commissioner, 469 F.2d 1189, 1192 (3d Cir. 1972),

aff’g T.C. Memo. 1970-307; M. W. Wood Enters., Inc. v. United States, 538 F.

Supp. 974, 975 (E.D. Pa. 1982).

      However, in such an analysis no single criterion or group of criteria can

“provide a conclusive answer in the kaleidoscopic circumstances which individual

cases present.” See Fin Hay Realty Co., 398 F.2d at 697. Moreover, the

enumerated factors should be used only as aids in analyzing the economic reality

of the transaction, that is, whether there is actually a contribution to capital or a

true loan for purposes of a bad debt deduction in income tax computation. Id.7

      The factors outlined in Fin Hay fall roughly into three categories: (1) the

intent of the parties; (2) the form of the instrument; and (3) the objective economic

reality of the transaction as it relates to the risks taken by investors. See Fuscaldo

v. United States, No. 00-CV-2486, 2001 WL 1519684, at *5 (E.D. Pa. Oct. 30,

2001); Fischer v. United States, 441 F. Supp. at 36. We now analyze CLCL’s


      7
        See also Scriptomatic Inc. v. United States, 555 F.2d at 367; Joseph
Lupowitz Sons, Inc. v. Commissioner, 497 F.2d 862 (3d Cir. 1974), aff’g in part,
remanding in part T.C. Memo. 1972-238; Trans-Atl. Co. v. Commissioner, 469
F.2d at 1192-1193; Dixie Dairies Corp v. Commissioner, 74 T.C. 476, 493-494
(1980) (finding that due to differing factual circumstances under which debt-
equity questions arise, where not all the criteria are pertinent, an analysis of a
lesser number will suffice); Fischer v. United States, 441 F. Supp. 32, 36 (E.D. Pa.
1977), aff’d, 582 F.2d 1274 (3d Cir. 1978).
                                       -22-

[*22] advances according to those three categories of factors--form, intent, and

economic reality--and we conclude that Mr. Sensenig failed to prove that those

advances were bona fide loans rather than contributions to capital or equity

investments.

               2.   Analysis

                    a.   Form

      As the foregoing primer illustrates, much debt-vs.-equity controversy

involves ostensible loan instruments that have some characteristics of equity.

Those cases require a comparison of the ostensible loan form of a transaction with

its arguable equity substance. This case, however, is not one that presents “an

investment which is in form a debt”, Fin Hay Realty Co., 398 F.2d at 696, but

which may have equity characteristics. Rather, in this case the investment has

little or no form. There is no loan agreement providing for repayment of CLCL’s

advances; there is in fact no written agreement of any sort; and Mr. Sensenig never

made any formal demands for repayment.8 (Fin Hay factors 2 and 3.)




      8
       Courts have declined to characterize an advance as a genuine loan when the
transferor fails to take reasonable measures to secure repayment. Geftman v.
Commissioner, 154 F.3d 61, 74 (3d Cir. 1998), rev’g in part, vacating in part T.C.
Memo. 1996-447.
                                          -23-

[*23] The absence of an unconditional right to demand payment is practically

conclusive that an advance is an equity investment rather than a loan for which an

advancing taxpayer might be entitled to claim a deduction for a bad debt loss.

Secs. 166(a), 385; Fischer v. United States, 441 F. Supp. at 37 (Fin Hay factor 7);

Scriptomatic Inc. v. United States, 397 F. Supp. 753, 759 (E.D. Pa. 1975). Thus,

courts have found the lack of any formality to be inimical to a contention that a

loan exists when there is no provision for interest, no enforceable obligation to

repay the funds advanced, no maturity date, and no provision for superiority.

Fischer, 441 F. Supp. at 37; see also PepsiCo Puerto Rico, Inc. v. Commissioner,

T.C. Memo. 2012-269 (finding that a definite maturity date for payment, without

reservation or condition, is a fundamental characteristic of a debt and that if a

financial instrument does not provide any means to ensure payment of interest, it

is a strong indication of an equity interest).

      The salient fact of this case is the lack of written evidence demonstrating

that there was a valid and enforceable obligation to repay on the part of any of the

companies at issue that received advances from Mr. Sensenig through CLCL. (Fin

Hay factor 11.) There is no written evidence of an enforceable obligation between

CLCL and any of the companies at issue, much less a provision for a fixed

maturity date or a fixed rate of interest. (Fin Hay factors 10 and 13.)
                                          -24-

[*24] Mr. Sensenig is not a financially unsophisticated person unaccustomed to

having written agreements. On the contrary, his arrangements with those who

invested in CLCL’s “investor pool” were duly reflected in demand notes that

stated rates of interest, and to those lenders he issued quarterly statements and

Forms 1099 showing the interest that accrued in their favor. The loans allegedly

made by CLCL, however, are undocumented.

       Uncorroborated oral testimony is insufficient to satisfy the taxpayer’s

burden in an equity-versus-debt determination. See Steiner v. Commissioner, T.C.

Memo. 1981-212, aff’d without published opinion, 688 F.2d 825 (3d Cir. 1982);

Fischer, 441 F. Supp. at 37. The absence of any type of formality typically

associated with loans supports the conclusion that the advances were contributions

to capital.

                    b.     Intent

       At trial Mr. Sensenig testified that “[t]he intent [of] both sides was that this

is a loan and that there would be no profit-sharing. That interest would be paid

and only interest would be paid, and that principal and only principal would be

repaid.” There was, he says, an understanding between the parties that “the

borrower will post it as borrowed money and the lender will post it as money
                                          -25-

[*25] loaned out”; and consistent with that, Mr. Sensenig offered CLCL journal

entries that labeled some advances as loans.

         However, for only one of the companies at issue, WSC, did Mr. Sensenig

provide even shareholders’ and directors’ resolutions authorizing WSC to borrow

from CLCL; and even in that instance, there is no further documentation to

demonstrate that thereafter the authority was actually exercised and a loan was in

fact made to WSC, or that WSC had an obligation to repay such a loan. Instead,

Mr. Sensenig stated that on behalf of CLCL he entered into oral agreements with

G-L, LFP, and WSC to lend money (lines of credit) and that those companies

agreed to borrow the same amounts. But apart from his testimony, there is no

evidence in the record that reflects that CLCL or any of the companies at issue

treated the monetary advances from CLCL as draws on lines of credit, other than

the aforementioned (scattered) journal entries of CLCL.

         “[C]onclusory declarations that the parties intended to create debts should

carry little weight.” Fischer, 441 F. Supp. at 37; see also Dunmire v.

Commissioner, T.C. Memo. 1981-372. The Court provided Mr. Sensenig with the

opportunity to present evidence to corroborate his testimony, but he was unable to

do so.
                                        -26-

[*26] “In the absence of direct evidence of intent, the nature of the transaction

may be inferred from its objective characteristics”. Geftman v. Commissioner,

154 F.3d 61, 68 (1998), rev’g in part, vacating in part T.C. Memo. 1996-

447.9 In this case, we meet again the blunt, objective fact that no loans are

documented.

                   c.     Economic reality

      The third category of factors pertains to the economic reality of the

advances. “A court may ascertain the true nature of an asserted loan transaction

by measuring the transaction against the ‘economic reality of the marketplace’ to

determine whether a third-party lender would extend credit under similar

circumstances.” Id. at 76 (quoting Scriptomatic, Inc., 555 F.2d at 367-368).

      If an outside lender would not have lent funds to the corporation on the

same terms as did the insider, an inference arises that the advance is not a bona

fide loan. See Fin Hay Realty Co., 398 F.2d at 697; Fischer, 441 F. Supp at 38

(“The acid test of the economic reality of a purported debt is whether an unrelated

outside party would have advanced funds under like circumstances”).

      9
       Such objective characteristics may include “the presence or absence of debt
instruments, collateral, interest provisions, repayment schedules or deadlines,
book entries recording loan balances or interest payments, actual repayments, and
any other attributes indicative of an enforceable obligation to repay the sums
advanced.” Geftman v. Commissioner, 154 F.3d at 68.
                                        -27-

[*27] Mr. Sensenig stated that the companies he chose to finance were start-up

ventures that could not obtain financing from unrelated banks. (Fin Hay factor 4.)

As a matter of CLCL policy, if a start-up company had other sources or means to

borrow, CLCL would not advance money to it. (And other than the money that

CLCL provided to the companies, no further capital contributions were made by

anyone else.) The three companies at issue were objectively risky debtors, and an

unrelated prospective lender would probably have concluded that they would

likely be unable to repay any proposed loan.

      Mr. Sensenig emphasized that, with respect to the advances at issue here, he

generated no formal written financial projections and that he did not know what

those projections would be. He was satisfied to go with the “gut feel of everybody

involved”. He considered business plans a waste of time and emphasized the

importance of being able to “turn on a dime” on the basis of the facts of the

moment, unconstrained by any formal plan. We think an unrelated lender would

have considered this approach too cavalier.

      When Mr. Sensenig decided to write off the advance to LFP, it was because

he believed the possibility the company would be profitable was remote.10 And


      10
       Specifically for LFP, Mr. Sensenig did not believe any revenue generated
from the patent to polish rebar would be sufficient to repay the debt.
                                         -28-

[*28] yet CLCL continued to provide financing (of approximately $9 million) to

all three companies after the year 2005 for which the bad debt deduction was

claimed. No prudent lender would have continued to advance money to any of

these companies under such circumstances. Here, the amounts advanced to G-L,

LFP, and WSC were, as a matter of economic reality, placed at the risk of the

businesses and more closely resembled venture capital than loans. (Fin Hay factor

6.) Steiner v. Commissioner, T.C. Memo. 1981-212 (where advances are placed at

the risk of the business, they are typically viewed as contributions to capital rather

than loans).

      Since Congress has chosen to give different tax consequences to debt and

equity, it “would do violence to the congressional policy” to treat as debt a

purported loan that “is so risky that it can properly be regarded only as venture

capital.” Fischer, 441 F. Supp. at 38 (quoting Gilbert v. Commissioner, 248 F.2d

399, 407 (2d Cir. 1957), remanding T.C. Memo. 1956-137).

      To the same effect, an advance may have the economic substance of a loan

where the funds are advanced with a reasonable expectation of repayment

regardless of the success of the venture or are placed at the risk of the business.

Steiner v. Commissioner, T.C. Memo. 1981-212. Mr. Sensenig’s expectation of

repayment to CLCL, however, was completely dependent on the future financial
                                         -29-

[*29] success of the companies (which were not successful). See Scriptomatic,

Inc., 397 F. Supp. at 764 (holding advances were not debt where repayment “can

only be reasonably assured by the chance of profits or from the liquidation of the

business”). Repayment of any amount advanced by CLCL to one of the

companies was not anticipated until the project had been “completed”. Moreover,

as to WSC, any expectation of repayment was even more remote, given that

CLCL’s interest was necessarily subordinate to the interest of WSC’s prior

mortgage lender. (Fin Hay factor 8.)

      Also at odds with a conclusion that this was a genuine loan transaction is

Mr. Sensenig’s not charging any loan origination fees for the advances and his

lack of interest in obtaining third-party audits, financial statements, or credit

reports for the companies he had chosen to invest in.

      CLCL’s advances simply do not have the appearance of loans. We believe

that no reasonable third-party lender would have extended money to these

companies when none of the objective attributes which denote a bona fide loan are

present, including a written promise of repayment, a repayment schedule, and

security for the loan.

      The transfers simply did not give rise to a reasonable expectation or

enforceable obligation of repayment. For these reasons, we find that the
                                       -30-

[*30] relationship between Mr. Sensenig and CLCL on the one hand and the three

companies on the other was not that of creditor and debtor, and we conclude that

Mr. Sensenig’s advances of CLCL funds were in substance equity and that the IRS

properly disallowed the deduction for tax year 2005.

      C.    Worthlessness

      The Sensenigs’ contention of worthless debt fails also because they did not

show the extent to which the supposed debts were indeed worthless in 2005. We

accept that the 2005 cease-and-desist order was a major harmful event for CLCL

and the companies in which it invested; but whether and when that event caused

worthlessness was not demonstrated. Over the time that this controversy has been

pending between the IRS and Mr. Sensenig, he has been inconsistent with regard

to whether claiming the bad debt deduction for 2005 was proper and which

company was the debtor. (Fin Hay factor 1.) The 2005 Form 1120S that Mr.

Sensenig filed for CLCL does not identify the source of the bad debt deduction.

During the IRS’s examination, Mr. Sensenig and his accountant, Mr. Smith, stated

that the 2005 bad debt deduction was claimed by CLCL for loans to G-L and LFP.

(This position was consistent with CLCL’s general ledger for 2005, on which the

total bad debt included a complete write-off by CLCL of the advances to G-L and
                                        -31-

[*31] LFP, and yet CLCL continued to advance funds to both companies in

subsequent years.)

      However, later in the examination and also in his petition, Mr. Sensenig

conceded the bad debt deduction and explained that he “was in fact surprised that

his bookkeeper had claimed it and admits that he missed the error when signing

the tax return.” No other companies were discussed during the examination.

      Later in his petition, contradicting himself yet again, Mr. Sensenig included

a handwritten page (which he referred as a “footnote”) stating that “the years

following 2005 events have proven that the bad debt as claimed in 2005 was

correct after all and should have been allowed as filed.” Mr. Sensenig now

maintains that the bad debt was related to the advances made to WSC and not only

to G-L or LFP; but there is no documentary evidence that CLCL wrote off any

portion of the WSC debts in 2005 on its books; and after the 2005 bad debt

deduction, WSC was still in operation. (Likewise, as of May 2007, G-L and LFP

were still receiving funding from CLCL to pay for business operations.)

      Given Mr. Sensenig’s shifting position about who owed the supposed bad

debts and whether those debts had become worthless, we cannot give much weight

to his testimony about worthlessness. More important, he put on no evidence as to

the financial condition of the three “borrower” companies as of December 31,
                                        -32-

[*32] 2005, the end of the remaining year at issue. The Sensenigs did not carry

their burden to prove that any debts were worthless in 2005, and we will sustain

the IRS’s disallowance of the bad debt deductions.

III.   Accuracy-related penalty

       A taxpayer is liable for an accuracy-related penalty as to any portion of an

underpayment attributable to, among other things, a substantial understatement of

income tax or negligence. Sec. 6662(a) and (b)(1) and (2). There is a substantial

understatement of income tax if the amount of the understatement exceeds the

greater of 10% of the tax required to be shown on the return or $5,000. Sec.

6662(d)(1)(A); 26 C.F.R. sec. 1.6662-4(a), Income Tax Regs.

       The Commissioner bears the burden of production with respect to this

penalty. Sec. 7491(c). The IRS’s NOD, which made determinations we have

sustained, determined an underpayment due to an understatement of income tax in

excess of both $5,000 and 10% of the total tax required to be shown on

petitioner’s 2005 return. And even if the amount of the deficiency is recomputed

under Rule 155, it is clear that the understatement will remain “substantial” for

purposes of section 6662(a)(1)(A). The Commissioner has thus carried his burden

of production by demonstrating a “substantial understatement of income tax.”
                                         -33-

[*33] Once the Commissioner has met the burden of production, the taxpayer

must come forward with persuasive evidence that the penalty is inappropriate

because, for example, he or she acted with reasonable cause and in good faith.

Sec. 6664(c)(1); Higbee v. Commissioner, 116 T.C. at 448-449. The decision as

to whether a taxpayer acted with reasonable cause and in good faith is made on a

case-by-case basis, taking into account all pertinent facts and circumstances. See

26 C.F.R. sec. 1.6664-4(b)(1). Generally, the most important factor is the extent

of the taxpayer’s effort to assess her or his proper tax liability. Id.; see also Shaw

v. Commissioner, T.C. Memo. 2013-170, aff’d, 623 F. App’x 467 (9th Cir. 2015);

Halby v. Commissioner, T.C. Memo. 2009-204. Other circumstances include the

experience, knowledge, and education of the taxpayer, as well as the extent to

which the taxpayer reasonably and in good faith relied on the advice of a

competent professional tax adviser. 26 C.F.R. sec. 1.6664-4(c)(1); see

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299

F.3d 221 (3d Cir. 2002).

      When asked at trial to provide any argument as to why he should not be held

liable for the penalty, Mr. Sensenig stated: “If I owe the tax, I owe the penalty in

my opinion.” We agree. Mr. Sensenig does not rely on a claim of reliance on

advice; rather, he takes full responsibility for the information reported on the
                                         -34-

[*34] return and does not attribute any fault to his C.P.A. employee who prepared

CLCL’s 2005 tax return. Because Mr. Sensenig was a long-time licensed public

accountant and owner of an accounting practice--which at one point prepared over

300 returns per year--his professional experience should have prompted more of

an effort on his part to ensure that his bad debt deduction was proper. His

uncertainty as to which companies’ debts warranted the bad debt deduction and his

surprise at learning which companies’ debts had been relied on to support the

deduction demonstrate a lack of a diligent effort to ascertain the validity of the tax

deduction.

      Under these circumstances, we sustain the IRS’s determination of the

accuracy-related penalty.

      To reflect the foregoing,


                                                Decision will be entered under

                                        Rule 155.
