                        T.C. Memo. 2000-292



                      UNITED STATES TAX COURT



        J. MICHAEL SHEDD AND MARITA SHEDD, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent

           J&J MANAGEMENT GROUP, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 3209-99, 3210-99.       Filed September 18, 2000.



     Marc A. Letvin, for petitioners.

     Gary R. Shuler, Jr. and Matthew J. Fritz, for respondent.


             MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:   These consolidated cases involve income tax

deficiencies determined by respondent for petitioners’ 1994 and

1995 taxable years.   Respondent determined income tax

deficiencies and penalties for petitioners J. Michael and Marita

Shedd, docket No. 3209-99, as follows:
                                     - 2 -

                                                Penalty
              Year      Deficiency           Sec. 6662(a)1
              1994       $26,835                $5,367
              1995        26,387                 5,277

      Respondent determined income tax deficiencies and penalties

for   petitioner J&J Management Group, Inc. (J&J), docket No.

3210-99, as follows:

                                                Penalty
              Year      Deficiency           Sec. 6662(a)1
              1994       $3,402                 $680
              1995       31,913                6,383
      1
       Respondent has conceded that petitioners are not liable
for sec. 6662(a) penalties for the 1994 or 1995 taxable year.
Respondent concedes that the Shedds did not receive constructive
dividends for 1994.

          Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the taxable periods under

consideration, and all Rule references are to the Tax Court Rules

of Practice and Procedure.

      The primary issue for our consideration is whether advances

from J&J to TLC Management, Inc. (TLC), were business loans or

contributions to capital.      If we decide that they were business

loans, we must then decide whether J&J is entitled to a bad debt

deduction under section 166.      If we find that the advances were

contributions to capital, we must then decide whether the

advances should be treated as constructive dividends from J&J to

the Shedds, in light of Mr. Shedd’s ownership of stock in both

J&J and TLC.
                               - 3 -



                    FINDINGS OF FACT

     The parties’ stipulation of facts and the exhibits are

incorporated herein by this reference.

     Petitioners J. Michael and Marita Shedd (the Shedds) are

husband and wife and resided in Livonia, Michigan, at the time

their petition was filed.   The Shedds each owned 50 percent of

J&J, whose principal place of business was Romulus, Michigan, at

the time its petition was filed.    J&J was engaged in the freight

forwarding business in the Detroit, Michigan, metropolitan area.

Mr. Shedd owned 100 percent of TLC, which was engaged in a

freight forwarding business in Cleveland, Ohio.   J&J and TLC are

related due to Mr. Shedd’s stock ownership.   J&J began operating

in June 1988, and Mrs. Shedd maintained its books without

receiving compensation.   Mr. Shedd was president of J&J.   J&J did

not declare or pay any dividends.

     J&J was the first of the Shedds’ companies to become

involved in a network of independent freight forwarding

contractors named SEKO.   Payments were made by freight customers

to SEKO, which retained 40 percent of adjusted revenues and

remitted the balance to the contractors.   SEKO also retained the

right to apply customer receipts to outstanding indebtedness and

was entitled to maintain contractor security deposits.    Under its

agreement with SEKO, J&J’s shareholders were required to
                                - 4 -

personally guarantee performance of the contract and of all of

J&J’s financial obligations to SEKO.

     J&J became indebted to SEKO in its first year of business.

In May 1989, J&J executed a promissory note to SEKO for an amount

in excess of $155,000.   The borrowed funds were used to pay J&J’s

operating expenses.   The promissory note reflected an unsecured

loan without interest and with payments scheduled to end on June

1, 1993, or upon termination of the independent contractor

agreement between J&J and SEKO.   The payments were made from the

periodic settlement of commissions owed by SEKO to J&J.    SEKO

would reduce the commission to J&J by an amount equal to 10

percent of the commission.    Under this payment schedule, J&J paid

its indebtedness to SEKO in approximately 1 year.

     TLC was also incorporated in 1988 but did not begin

operations until 1992 when it received its Ohio business

certificate.   Mr. Shedd was the president and treasurer, and Mrs.

Shedd was secretary of TLC.   TLC also contracted with SEKO and

established a customer base due to the SEKO affiliation.

     TLC was incorporated with $500 paid in capital, and no

additional capital was contributed by the Shedds.   Advances in

the total amount of $119,700 were made by J&J to TLC from

February 1992 through October 1995 for operating expenses

evidenced by unsecured demand notes bearing 7-percent interest

and signed by Mrs. Shedd, as TLC’s secretary, as follows:
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                       Amount of
Dates of advances      advances      Date & amount of note
2/21/92 to 9/18/92     $49,000       10/1/92    $36,513.92
10/5/92 to 6/4/93       16,500       10/1/93      6,500.00
10/5/93 to 9/15/94      12,000       10/3/94      3,872.21
10/2/94 to 6/9/95       42,200       10/2/95     43,553.55

       Total           119,700                   90,439.68

J&J did not require any personal guaranties from the Shedds on

the advances to TLC.    No repayment schedule was established, and

J&J made no demand of TLC for payment of the principal or

interest on the notes.

       TLC was dissolved prior to April 1995, and it filed a

“Notification of Dissolution or Surrender” with the State of Ohio

Department of Taxation indicating that it ceased or would cease

operations on April 1, 1995.     On its 1995 Federal income tax

return, TLC reported $90,440 income due from the forgiveness of

the above-described debt.    J&J claimed the amount as a bad debt

deduction and respondent disallowed the deduction.

                                 OPINION

       Respondent contends that J&J’s advances to TLC, a

corporation wholly owned by J&J’s shareholders, constituted

equity investments in those companies.      As such, TLC’s subsequent

failure resulted in capital as opposed to ordinary losses for

J&J.    Respondent also contends that the funds advanced to TLC by

J&J were constructive dividends.      Petitioners counter that the

advances constituted valid debt between J&J and TLC and that

TLC's inability to repay the debt resulted in worthlessness and
                                 - 6 -

entitled J&J to an ordinary loss deduction under section 166.

Because of petitioners’ characterization of the advances as bona

fide loans, they contend that the advancing of funds was not a

constructive dividend.

Bad Debt

     Bad debts which become worthless within the taxable year are

deductible by a corporate taxpayer as ordinary losses under

section 166(a)(1).    The right to a deduction is limited to

genuine debt, and capital contributions are not considered debt

for the purposes of section 166(a)(1).    See Raymond v. United

States, 511 F.2d 185, 189 (6th Cir. 1975).    Capital

contributions, on the other hand, may result in a capital loss

for a shareholder if the stock becomes worthless.    See sec.

165(g)(1).

     The determination of whether advances to a corporation are

loans or capital contributions depends on whether there is an

intention to create an unconditional obligation to repay the

advances.    See Raymond v. Commissioner, supra at 190.   Advances

between related corporations are subject to particular scrutiny

because the relationship more readily facilitates fictionalized

debt.    See In re Uneco, Inc., 532 F.2d 1204, 1207 (8th Cir.

1976).     Petitioners must show that the advances were loans rather

than capital contributions as determined by respondent.     See Rule

142(a); Welch v. Helvering, 290 U.S. 111 (1933).
                                - 7 -

     In order to show entitlement to an ordinary loss under

section 166, petitioners must establish that (1) a bona fide debt

existed between J&J and TLC which obligated TLC to pay J&J a

fixed or determinable sum of money, (2) the debt was created or

acquired in connection with a trade or business of J&J, and (3)

the debt became worthless when claimed.   See United States v.

Generes, 405 U.S. 93 (1972); Calumet Indus., Inc. v.

Commissioner, 95 T.C. 257, 285 (1990); Beaver v. Commissioner, 55

T.C. 85, 91 (1970); Black v. Commissioner, 52 T.C. 147, 151

(1969).   A gift or contribution to capital is not debt within the

meaning of section 166.   See Calumet Indus., Inc. v.

Commissioner, supra at 284; Kean v. Commissioner, 91 T.C. 575,

594 (1988).

     Accordingly, petitioners must show that there was "a genuine

intention to create a debt, with a reasonable expectation of

repayment" and that the intention was consistent with the

"economic reality of creating a debtor-creditor relationship".

Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973).

Whether the requisite intention to create a true debtor-creditor

relationship existed is a question of fact to be determined from

a review of all the evidence.   See id.   Factors that have been

considered in the analysis of this issue include (1) the names

given to the certificates evidencing the indebtedness, (2) the

presence or absence of a fixed maturity date, (3) the source of
                                - 8 -

payments, (4) the right to enforce payments, (5) participation in

management as a result of the advances, (6) the status of the

advances in relation to regular corporate creditors, (7) the

ratio of debt to capital of the corporation, (8) the ability of

the corporation to obtain credit from outside sources, (9) the

use to which the advances were put, (10) the failure of the

debtor to repay, and (11) the risk involved in making the

advances.   See Roth Steel Tube Co. v. Commissioner, 800 F.2d 625,

630 (6th Cir. 1986); Calumet Indus., Inc. v. Commissioner, supra;

Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493 (1980).      No

single factor is determinative, and not all factors are

applicable in each case.    See Dixie Dairies Corp. v.

Commissioner, supra.   "The various factors * * * are only aids in

answering the ultimate question whether the investment, analyzed

in terms of its economic reality, constitutes risk capital

entirely subject to the fortunes of the corporate venture or

represents a strict debtor-creditor relationship."       Fin Hay

Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968).

     We consider each of the suggested factors in our analysis of

whether petitioners created bona fide debt rather than equity, as

determined by respondent.

1.   Name Given Instruments Evidencing Indebtedness

      The issuance of a note may be indicative of bona fide debt.

See Estate of Mixon v. Commissioner, 464 F.2d 394, 402 (5th Cir.
                               - 9 -

1972).   The existence of a note, however, is not in and of itself

conclusive.   An unsecured note, with no payments made thereon,

weighs towards equity.   See Stinnett’s Pontiac Serv., Inc. v.

Commissioner, 730 F.2d 634 (11th Cir. 1984), affg. T.C. Memo.

1982-314; Estate of Van Anda v. Commissioner, 12 T.C. 1158, 1162

(1949), affd. per curiam 192 F.2d 391 (2d Cir. 1951).

     Here, notes were signed, but they were not signed until the

end of the fiscal year in which funds had been advanced.

Further, the notes were executed in amounts that were less than

the amount that had been advanced.     Furthermore, the evidence

shows that no payments were ever made on these unsecured

advances.   When a transaction involves a closely held

corporation, the forms and labels assigned to a transaction may

mean little due to the parties’ ability to mold the transaction

to their will.   See Anchor Natl. Life Ins. Co. v. Commissioner,

93 T.C. 382, 407 (1989).   For these reasons, we find that the

notes have only limited probative value in our evaluation of

whether the advances were bona fide indebtedness.



2.   Presence or Absence of Fixed Maturity Date and Schedule of

Payments

     Here, no schedule of payments or due date was established.

Petitioners’ claim that demand notes weigh in their favor, but
                                 - 10 -

that argument was of little import because no demand for payment

was made.

3.   Source of Repayments

      If the expectation of repayment depends solely on the

success of the borrower's business, the transaction has the

appearance of a capital contribution.      See In re Lane 742 F.2d

1311, 1314 (11th Cir. 1984); Estate of Mixon v. Commissioner,

supra at 405.    An expectation of repayment solely from corporate

earnings is not indicative of a bona fide debt.       See In re Lane,

supra at 1314.   There has been no showing of any other source of

repayment other than the TLC’s business receipts.

4.   The Right To Enforce Payments

      A definite obligation to repay principal and interest favors

the existence of debt.      See Stinnett’s Pontiac Serv., Inc. v.

Commissioner, supra at 639.      Repayment that is within the

discretion of the parties and conditioned upon the occurrence of

certain events is more like equity.       See id.   Even where there is

a basic right to enforce payment, failure to take customary steps

to ensure payment-–such as securing the advance or establishing a

sinking fund-–may indicate an equity rather than debt

relationship.    See In re Lane, supra at 1317.

      J&J made no attempt to demand payment from TLC.      Further,

J&J did not require security or a sinking fund.       TLC had no

obligation to repay on a fixed schedule or by a certain date.
                               - 11 -

The evidence does not support petitioners’ claim that they

expected to be repaid.

5.   Participation in Management as a Result of the Advances

      Normally, acquisition of management responsibilities by the

party advancing funds is more likely to be evidence of an equity

relationship.   See Stinnett’s Pontiac Serv., Inc. v.

Commissioner, supra at 639.    Here, however, Mr. Shedd was already

the managing shareholder of J&J and TLC, and so this factor is

neutralized in this case.

6.   The Status of the Advances in Relation to Regular Corporate

Creditors

      Subordination of advances to claims of other creditors

indicates that the advances were capital contributions and not

loans.   See id.   There is insufficient evidence to judge the

weight of this factor.

7.   The Ratio of Debt to Capital of the Corporation

      Thin or inadequate capitalization is strong evidence that

the advances are capital contributions rather than loans.    See

Stinnett’s Pontiac Serv., Inc. v. Commissioner, supra at 639;

Estate of Mixon v. Commissioner, supra at 408.     Here, Mr. Shedd

testified that TLC received $500 of initial capitalization and no

further contributions were received from the Shedds.    Comparing

capital of $500 with over $90,000 in advances, it appears that

the advances were more likely capital in nature.
                              - 12 -

8.   The Ability of the Corporation To Obtain Credit From Outside

Sources

      If a party receiving an advance can borrow funds from

another lender in an arm’s-length transaction on similar terms,

the advance may appear to be debt.     See Electronic Modules Corp.

v. United States, 695 F.2d 1367, 1370 (Fed. Cir. 1982); Estate of

Mixon v. Commissioner, supra at 410.     This factor is strongest

for petitioners.   At trial, the chief financial officer of SEKO

testified that SEKO would have made the loans to TLC, up to the

$90,000 that was actually advanced.     He spoke of the industry

norm of thin capitalization and of the practice of advancing

funds to companies losing money for a certain period of time.

Though the independent contractor agreement addresses guaranties,

he testified that no personal guaranties were required on the

notes to the contractors.

      If J&J had advanced the funds in the exact same manner that

SEKO advanced funds to its independent contractors, this factor

would have had more probative value in petitioners’ favor.     In

its loan agreement, SEKO arranges to withhold 10 percent of any

commission payment due to the independent contractor.     By doing

so, the independent contractor is not given a choice of which

creditor to pay.   The note also establishes a termination date by

which time the note must be paid.    These two important factors
                               - 13 -

are not present in the advances to TLC and do not support an

intention by J&J to collect on the advances.

9.    The Use to Which the Advances Were Put

       Use of advances to meet the daily operating needs of the

corporation, rather than to purchase capital assets, is

indicative of bona fide indebtedness.      See Stinnett’s Pontiac

Serv., Inc. v. Commissioner, 730 F.2d at 640; Raymond v. United

States, 511 F.2d at 191; Estate of Mixon v. Commissioner, 464

F.2d at 410.    The advanced funds were used to pay the operating

expenses of TLC.   Accordingly, this factor favors petitioners’

position.

10.   The Failure of the Debtor To Repay

       The absence of payments of principal or interest is a strong

indication that the advances were capital contributions rather

than loans.    See Stinnett’s Pontiac Serv., Inc. v. Commissioner,

supra at 640; Raymond v. Commissioner, supra at 191; Austin

Village, Inc. v. United States, 432 F.2d 741, 745 (1970).     It is

undisputed that TLC never made a payment over the 4-year period

when it received funds from J&J, nor did J&J make any demand for

payment.    Accordingly, it appears that J&J never intended to

compel repayment of the advances.

11.    The Risk Involved in Making The Advances

       The absence of security for the advances indicates that the

advances were more likely capital contributions.     See In re Lane,
                              - 14 -

742 F.2d at 1317; Raymond v. United States, supra at 191; Austin

Village, Inc. v. Commissioner, supra at 745.   J&J did not require

security from TLC.

     Having weighed all the factors, we hold that J&J’s advances

were capital contributions and not bona fide loans. The fact that

SEKO would have been willing to lend to TLC weighed in favor of

bona fide indebtedness, but the differences in the terms and the

ability of SEKO to collect directly from the receipts of its

borrowers stripped away much of the weight.

     Having decided the advances were contributions to capital,

we must now decide whether those contributions should be treated

as constructive dividends to the Shedds.

Constructive Dividend to Common Shareholder

     Generally, distributions of property of a corporation to a

shareholder, with respect to the shareholder’s stock, out of its

earnings and profits are taxable to the shareholder as dividend

income to the extent of the availability of corporate earnings

and profits.   See secs. 61(a)(7), 301(a), 301(c), 316(a).   Here

we consider whether the advances to TLC were constructive

dividend to the Shedds, even though there was no formal dividend

declaration.   See Wilkof v. Commissioner, T.C. Memo. 1978-496,

affd. 636 F.2d 1139 (6th Cir. 1981).   A transfer of property

between related corporations may constitute a dividend to common
                              - 15 -

shareholders even though no funds or property are directly

received by them.

     Two tests are normally employed to decide whether a transfer

between related corporations constitutes a constructive dividend.

One is an objective distribution test and the other a subjective

test of primary purpose, both of which must be satisfied.        See

Stinnett's Pontiac Serv., Inc. v. Commissioner, supra at 641.

     First, there must be a distribution from the transferring

corporation's earnings and profits; i.e., the transferee

corporation must receive something at the expense of the

transferor.   This test requires property to leave the control of

the transferor corporation in a way that allows a common

shareholder to directly or indirectly control the property

through some other instrumentality.    Where property is

transferred between related corporations, a common shareholder

does not personally receive the property.    Therefore, a

distribution is thought to occur when a transferee corporation

attains an increase in assets or control at the expense of a

transferor corporation.   The amount of such distribution is

measured by the loss to the transferring corporation.      See

Sammons v. Commissioner, 472 F.2d 449, 451, 453 (5th Cir. 1972),

affg. in part, revg. in part and remanding on other grounds T.C.

Memo. 1971-145; Stinnett's Pontiac Serv., Inc. v. Commissioner,
                               - 16 -

supra; Sparks Nugget, Inc. v. Commissioner, T.C. Memo. 1970-74,

affd. 458 F.2d 631 (9th Cir. 1972).

       Here, J&J made a capital contribution rather than a loan to

TLC.    When petitioner J&J advanced the funds to TLC, Mr. Shedd,

as president and sole shareholder of TLC, then had indirect

control over those funds.    The advance by J&J to TLC is

sufficient to meet the objective test.

       The second test is designed to differentiate between normal

business transactions of related corporations and those designed

primarily to benefit a common shareholder.    The primary or

dominant motivation for a distribution must be examined.     See

Sammons v. Commissioner, supra at 451-452.    The Shedds must show

a legitimate corporate or business justification which is the

primary cause for the advance and which is sufficient to overcome

the conclusion that Mr. Shedd, as the shareholder, primarily

benefited from the advance of funds.    A legitimate corporate

justification is demonstrated by showing that the distribution

would be in the best interest of the transferring corporation.

If justifiable business reasons exist that account for the

transfer, such reasons will suffice to override any incidental or

derivative benefit to a common shareholder.    See Wilkof v.

Commissioner, supra.    However, where a corporation's distribution

serves no legitimate corporate purpose, it must be treated as a

constructive dividend to the benefited shareholder.    See
                               - 17 -

Commissioner v. Riss, 374 F.2d 161, 167 (8th Cir. 1967), affg. in

part, revg. in part and remanding on another ground T.C. Memo.

1964-190.

     Mr. Shedd testified that J&J lent the money to TLC in order

to create a business with which it could share costs of

forwarding freight.    While this would be a valid business

purpose, the Shedds have presented no documentary or

corroborating evidence of any savings over the 4-year period

funds were advanced.    In this regard, petitioners contend that

requiring corroborating documentary evidence of the savings

effectively increases the level of their burden of proof from a

preponderance to “beyond a reasonable doubt”.      Petitioners have

confused the level of their burden with the need to provide

particulars or details of the savings.      Petitioners have merely

made the uncorroborated statement that there either could have

been or were savings.    They have not, however, explained how

those savings would or did occur.    Petitioners have not presented

sufficient documentary evidence or testimony explaining the

business purpose for the advances.      It has not been shown that

the Shedds were acting in J&J’s business interests when funds

were advanced to TLC.    Instead, it appears that Mr. Shedd was

acting in his own best interests as sole shareholder of TLC when

he caused the injection of additional capital into TLC, an
                             - 18 -

inadequately capitalized entity.   Accordingly, we hold that

petitioners Shedd realized a constructive dividend.

     To address concessions of the parties and to reflect the

foregoing,

                              Decisions will be entered

                         under Rule 155.
