                        T.C. Memo. 2003-54



                      UNITED STATES TAX COURT



              DELTA PLASTICS, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 10246-00.            Filed February 28, 2003.



     Tony L. Wilcox and David M. Graf, for petitioner.

     Kirk S. Chaberski, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   For 1996, respondent determined a deficiency

in petitioner’s Federal income tax of $31,873.
                               - 2 -

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue.

     The issue for decision is whether certain payments

petitioner made to its shareholders in 1996 should be treated as

deductible interest on shareholder loans or as nondeductible

dividends on shareholder equity.


                         FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

     At the time the petition was filed, petitioner’s principal

place of business was located in Hot Springs, Arkansas.

Petitioner was incorporated in the State of Arkansas on

October 12, 1992, and petitioner began operations in August of

1993.   Petitioner manufactures and sells plastic jars and lids

for use primarily in the cosmetic and pharmaceutical industries.

     From 1981 to 1987, Lothar Schweigert, petitioner’s principal

shareholder, owned a controlling interest in and was an officer

and employee of Santa Fe Plastics (Santa Fe), a successful

company based in Santa Fe Springs, California, that manufactured

and sold plastic products similar to those manufactured and sold

by petitioner.

     From 1981 to 1987, other of petitioner’s shareholders,

officers, and directors (namely Robert TeSelle, William D.

Maffit, Jan A. Strand, and Chris Rakhshan) also were employed in

various capacities at Santa Fe.    TeSelle was chief financial
                               - 3 -

officer, Maffit was production manager, Strand was head of sales

and marketing, and Rakhshan was plant manager.

     In October of 1987, Schweigert and TeSelle sold their

respective stock interests in Santa Fe to Kerr Glass

Manufacturing Corp.   In connection with the stock sale, both

Schweigert and TeSelle entered into covenants not to compete with

Santa Fe.   The covenants not to compete had a duration of 5 years

and apparently encompassed the entire United States.

     During 1991 and 1992, Maffit and Strand used their

understanding and knowledge of the plastics manufacturing

business to put together a business plan for petitioner that

projected an early likelihood of success and purported to improve

upon the model used to start and develop Santa Fe.   Prior to the

startup of petitioner’s operations in August of 1993, TeSelle,

Maffit, and Strand contacted and received commitments from former

customers of Santa Fe, signed contracts with suppliers and

equipment manufacturers, and otherwise prepared for petitioner to

begin operations.   The record is unclear as to Schweigert’s

participation in planning for the startup of petitioner.

     Prior to August of 1993, petitioner received as initial

capital a total of $183,500 in equity contributions from its

seven original shareholders.   The amount of each shareholder’s

initial equity contribution and the number and percentage of
                                   - 4 -

shares of stock in petitioner that each shareholder received is

set forth below:


                       Equity         Shares of          Percentage of
   Shareholder      Contribution     Common Stock        Common Stock
Lothar Schweigert    $ 88,000           880,000              47.96
Robert TeSelle         26,000           260,000              14.17
Jan Strand             16,500           165,000               8.99
William Maffit         16,500           165,000               8.99
Chris Rakhshan         16,500           165,000               8.99
Paul Stevenson         10,000           100,000               5.45
Daniel Kliska          10,000           100,000               5.45
                     $183,500         1,835,000             100.00


     Also, petitioner received a total of $2,322,838 in the form

of secured startup loans -- $2,169,013 from three unrelated

creditors and $153,825 from Schweigert.        Each secured loan was

evidenced by a promissory note executed on behalf of petitioner.
     In addition, petitioner received from a group of individuals

consisting of six of petitioner’s shareholders and one other

individual (collectively referred to hereinafter as the

“debenture holders”) funds totaling $1,337,500 (debenture funds).

Documents entitled debenture notes, executed on behalf of

petitioner in favor of the debenture holders, reflected the

debenture funds.

     The amount and percentage of total debenture funds received

by petitioner from each debenture holder are set forth below:
                                   - 5 -
                                Debenture                 Percent of
    Debenture Holders             Funds              Total Debenture Funds
    Lothar Schweigert          $ 687,000                     51.35
    Robert TeSelle                149,000                    11.14
    Jan Strand                     90,500                     6.77
    William Maffit                 90,500                     6.77
    Chris Rakhshan                 90,500                     6.77
    Paul Stevenson                115,000                     8.60
    Bernard Kliska*               115,000                     8.60
                               $1,337,500                   100.00

         *
            Bernard Kliska is the father of Daniel Kliska, a shareholder of
     petitioner.


     The written debenture notes, executed on August 1, 1993,

provided a 10-year schedule over which petitioner was to repay

the debenture holders the debenture funds and over which

petitioner was to pay the debenture holders amounts designated as

interest on the debenture funds, with the final payment due and

payable on June 15, 2003.      For the first 5 years of the debenture

notes, designated interest only was due and payable at the end of

the second, third, fourth, and fifth years at a stated interest

rate of 6 percent per year.1      For the second 5 years of the

debenture notes, principal and designated interest payments were

due and payable in equal monthly installments with a stated

interest rate of 1 percent above the prime rate of interest as

reported by the Wall Street Journal.

     Payments due on the debenture notes were not dependent upon

the profits or losses of petitioner.        Priority of payment on the


     1
        The debenture notes executed in favor of Schweigert,
TeSelle, Stevenson, and Kliska provided for a partial repayment
of principal at the end of the fifth year.
                                 - 6 -

debenture notes was equal among the debenture holders, and none

of the debenture holders received a management position or an

increase in management responsibilities with petitioner as a

result of the debenture funds petitioner received.

     The debenture notes were unsecured and subordinated to

claims of petitioner’s secured creditors, and, if not paid, the

debenture holders could enforce payment on the debenture notes

only if the holders of more than 50 percent of the value of all

the outstanding debenture notes joined in a proceeding against

petitioner to enforce payment.    From August of 1993 through the

time of trial in 2002, petitioner made all scheduled payments of

principal and designated interest due on the debenture notes.

     When petitioner began operations in August of 1993, the

above initial sources of funding (treating the debenture funds as

debt of petitioner and not as equity) resulted in a debt-to-

equity ratio for petitioner of approximately 26:1.   In just over

3 years, petitioner’s debt-to-equity ratio (treating the

debenture funds as debt of petitioner and not as equity) was

reduced to approximately 4:1.    The rapid decrease in petitioner’s

debt-to-equity ratio from 1993 to 1996 reflected petitioner’s

success in generating operating revenue.

     Comparative 1993-1996 yearend financial information for

petitioner (treating the debenture funds as debt of petitioner

and not as equity) is set forth below:
                                    - 7 -
                        Yearend Financial Information
                          1993          1994           1995           1996
Gross Revenue          $ 359,714     $5,246,515    $ 8,840,065     $13,580,098

Total Assets           4,287,799      7,391,115       12,001,652   14,611,042

Total Liabilities      4,119,859      6,638,531       10,443,799   11,392,737

Shareholder Equity       167,940        752,584        1,557,853    3,218,305

Debt-to-Equity Ratio       25:1             9:1           7:1           4:1


     As of the time of trial in 2002, petitioner had yet to

declare or pay a cash dividend.

     At the end of 1993, petitioner’s basis in its capital assets

including land, buildings, equipment, vehicles, tooling and

equipment was $3,598,463.

     For 1993-1996 and for Federal income tax purposes,

petitioner was a cash basis taxpayer.             On petitioner’s timely

filed 1996 corporate Federal income tax return, an interest

deduction of $93,746 was reflected for the payments designated as

interest that petitioner made in 1996 on the debenture notes.

     On audit, respondent determined that for Federal income tax

purposes the total debenture funds of $1,337,500 represented

equity to petitioner rather than debt, and respondent denied

petitioner’s claimed $93,746 interest deduction relating to the

designated interest paid in 1996 on the debenture funds.


                                   OPINION

     As a general rule, section 163(a) provides that a deduction

shall be allowed for all interest paid on indebtedness.
                               - 8 -

     Whether funds received by a corporation represent debt or

equity is a question of fact generally to be considered and

analyzed by reference to all of the evidence.2     Dixie Dairies

Corp. v. Commissioner, 74 T.C. 476, 493 (1980).

     Courts have identified and considered various factors in

deciding questions of debt versus equity.     See, e.g., In re

Uneco, Inc., 532 F.2d 1204, 1208 (8th Cir. 1976) (10 factors);

Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir.

1972) (13 factors); Am. Offshore, Inc. v. Commissioner, 97 T.C.

579, 602-606 (1991) (13 factors).      The various factors are not

equally significant, however, and no one factor is determinative.

John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946).

     Due to differing factual circumstances under which debt-

equity questions arise, not all of the factors are necessarily

relevant to each case.   Dixie Dairies Corp. v. Commissioner,

supra at 493-494.   The overall analysis of the Court seeks to

determine whether there was an intent to create a debt with a

reasonable expectation of repayment and, if so, whether that

intent comports with the economic reality of creating a debtor-


     2
        Whether a shift in the burden of proof is applicable in
this case is unclear. The parties do not raise the issue, and
the record does not indicate when respondent’s examination of
petitioner’s 1996 corporate Federal income tax return began. See
sec. 7491; Internal Revenue Service Restructuring and Reform Act
of 1998, Pub. L. 105-206, sec. 3001(a), 112 Stat. 726 (providing
that July 22, 1998, is the effective date of sec. 7491). In any
event, resolution of this case does not hinge on placement of the
burden of proof.
                                - 9 -

creditor relationship.     Litton Bus. Sys., Inc. v. Commissioner,

61 T.C. 367, 377 (1973).

     Of the 10 factors recognized and considered in In re Uneco,

supra, by the Court of Appeals for the Eighth Circuit (the Court

to which an appeal of this case lies), we discuss and apply below

those factors that are relevant to the facts of this case.3


Thin or Adequate Capitalization

     No specific ratio of debt to equity is determinative as to

whether a corporation is adequately capitalized.     2554-58 Creston

Corp. v. Commissioner, 40 T.C. 932, 937 n.3 (1963).

     In spite of petitioner’s initial debt-to-equity ratio of

26:1, prior to startup of petitioner, petitioner’s officers and

directors understood petitioner’s business and the plastics

manufacturing industry and reasonably projected that petitioner

would be successful.   As a result of revenues quickly generated

by its operations, petitioner’s debt-to-equity ratio was reduced

in just over 3 years to 4:1.    This reduction indicates to us, in

this case, that petitioner was adequately capitalized from its

inception.




     3
        We omit a discussion of whether a sinking fund was
established to retire the debenture notes. This factor was not
addressed by either party. Our discussion of the risk factor
involves a number of the In re Uneco, Inc., 532 F.2d 1204 (8th
Cir. 1976), factors.
                                - 10 -

Extent to Which Funds Were Used To Acquire Capital Assets

       The record is unclear as to exactly for what purpose the

debenture funds received by petitioner were used.    A substantial

portion of the debenture funds appears to have been used to

acquire capital assets.


Proportionality of Interest

       Funds received from shareholders in proportion to their

respective stock ownership interests may indicate equity

investments.     Am. Offshore, Inc. v. Commissioner, supra at 604

(citing Estate of Mixon v. United States, supra at 409).

       Each of petitioner’s debenture holders was either a

shareholder of petitioner or was related to a shareholder of

petitioner.    The debenture funds were transferred to petitioner

by the debenture holders, not in exact proportion, but in

comparable proportion to the respective stock interests of the

debenture holders.


Risk

       Petitioner’s obligation to repay the debenture funds was

unconditional.    Payments of principal and designated interest on

the debenture notes were not dependent upon profits of

petitioner, nor were payments excused or forgiven in the event

petitioner sustained losses.    Respondent argues that because the

debenture notes were unsecured and subordinated to the secured
                               - 11 -

debts of petitioner, payments on the debenture notes depended

solely on future earnings of petitioner which put the debenture

funds at an equal amount of risk as petitioner’s equity.

Reliance, however, upon future earnings for payment of a

purported debt generally does not cause the funds received by a

corporation to be treated as equity.    See J.S. Biritz Constr. Co.

v. Commissioner, 387 F.2d 451, 458-459 (8th Cir. 1967), revg.

T.C. Memo. 1966-227.


Third-Party Loans

     Funds are more likely to be treated as debt if at the time

the funds were received the corporation had credit available from

outside sources.    Am. Offshore, Inc. v. Commissioner, supra at

605 (citing Estate of Mixon v. United States, supra at 410).

     The evidence indicates that petitioner was successful in

obtaining secured loans from outside creditors, and at no time

was petitioner refused a loan from a third party.


Management Participation

     Funds received by a corporation will be more likely treated

as equity if, as a result of such receipt, the person

transferring the funds had a right to participate in the

management of the corporation.    Am. Offshore, Inc. v.

Commissioner, supra at 603.
                              - 12 -

     The credible evidence indicates that none of the debenture

holders was granted a management position or an increase in

voting rights as a result of the receipt of the debenture funds

by petitioner.


Payments

     A significant debt-equity factor is whether a corporation

repays its obligations on time.   See Fries v. Commissioner, T.C.

Memo. 1997-93 (citing In re Lane, 742 F.2d 1311, 1317 (11th Cir.

1984)).

     Petitioner has timely made all scheduled payments of

principal and designated interest due on the debenture notes.


Intent of the Parties

     In resolving debt-equity questions, both objective and

subjective evidence of a taxpayer’s intent are considered and

given weight in light of the particular circumstances of a case.

See In re Uneco, Inc., 532 F.2d 1204, 1209 (8th Cir. 1976).

     With regard to the debenture funds, credible trial testimony

was offered that a debtor-creditor relationship was intended

between petitioner and the debenture holders with regard to the

debenture funds.   The debenture notes were executed in favor of

each of the debenture holders.    The debenture holders expected

repayment of the debenture funds.   The fixed dates for the
                              - 13 -

payment of principal and designated interest set forth by the

debenture notes were honored by petitioner.

     The debenture holders’ expectation of repayment at the time

the debenture notes were executed was reasonable because the

debenture holders had an understanding and knowledge of

petitioner’s business and a reasonable expectation of its likely

success.   For 1993 through the time of trial in 2002, petitioner

timely made the principal and designated interest payments due on

the debenture notes, and a majority of the objective factors

indicate that a debtor-creditor relationship existed between

petitioner and the debenture holders with regard to the debenture

funds.

     We conclude that petitioner properly treated the $1,337,500

in debenture funds as debt.   For 1996, petitioner is entitled to

an interest deduction for the $93,746 it paid as interest on the

debenture notes.

     To reflect the foregoing,


                                      Decision will be entered

                                 for petitioner.
