                         T.C. Memo. 1998-408



                       UNITED STATES TAX COURT



  SALVADOR A. AND KATHLEEN M. GAUDIANO, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket Nos. 25712-96, 25713-96,       Filed November 13, 1998.
                25714-96, 25716-96.



    William C. Myers, Jr., for petitioners.

     Rebecca Dance Harris, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     VASQUEZ, Judge:    Respondent determined the following

deficiencies in petitioners' 1993 Federal income taxes:

              Petitioner                         Deficiency


     1 Cases of the following petitioners are consolidated
herewith: Gary D. Asher, docket No. 25713-96; Larry A. Asher,
docket No. 25714-96; and Randy C. and Kathleen R. Edgemon, docket
No. 25716-96.
                              - 2 -



     Salvador A. and Kathleen M. Gaudiano      $43,665
      (S. and K. Gaudiano)
     Gary D. Asher (G. Asher)                   43,281
     Larry A. Asher (L. Asher)                  43,858
     Randy C. and Kathleen R. Edgemon           44,342
      (R. and K. Edgemon)

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

     The issues for decision are:   (1) Whether petitioners2 are

entitled to increase their bases in the stock of Four A Coal Co.

(Four A), an S corporation, by their pro rata share of discharge

of indebtedness income (COD income) realized by Four A but

excluded by Four A pursuant to section 108(a); (2) whether the

transfer of certain mining equipment by Four A constituted a sale

or a lease and, if a sale, then the amount realized on the sale;

(3) whether G. Asher and L. Asher are entitled to ordinary losses

related to an alleged bad debt deduction claimed by Appolo Fuels,

Inc. (Appolo), an S corporation, for loans made to Four A.

                        FINDINGS OF FACT

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.   S. and K. Gaudiano and R.

and K. Edgemon resided in Knoxville, Tennessee, at the time they


     2
       We use the term "petitioners" to refer to S. Gaudiano, G.
Asher, L. Asher, and R. Edgemon.
                                - 3 -


filed their petitions.    G. Asher resided in Middlesboro,

Kentucky, at the time he filed his petition, and L. Asher resided

in Speedwell, Tennessee, at the time he filed his petition.

I.    Increase in Basis of Four A Stock

       During 1993, petitioners were shareholders of Four A, an S

corporation.    Petitioners each held a 25-percent interest in Four

A.

       During 1993, Four A had COD income of $1,289,048.   On

December 3, 1993, Four A filed for bankruptcy and was insolvent

within the meaning of section 108(d)(3).    On its Form 1120S for

1993, Four A excluded the COD income under section 108(a).

During that year, each petitioner increased his basis in his Four

A stock by $322,262--this represented his pro rata share of Four

A's COD income for the year.

II.    Increased Section 1231 Loss

       From May 1988 through February 1991, Four A mined coal which

it sold to Appolo.    Four A ceased its mining operations in

February 1991, and it leased its mining equipment (the equipment)

to Black Mountain Coal Mining Co., Inc. (Black Mountain).

Pursuant to the lease with Black Mountain (the lease), Black

Mountain mined the coal seams formerly mined by Four A and sold

the coal to Appolo.    Appolo paid Black Mountain a certain price

per ton for coal produced and paid Four A 50 cents per ton of

coal produced as a fee for Black Mountain's use of the equipment.
                               - 4 -


Under the terms of the lease, Four A retained title to the

equipment.

     During 1993, Four A and Black Mountain entered into a new

agreement concerning the equipment referred to by the parties as

a "Promissory Note and Agreement" (the agreement).    According to

the terms of the agreement, Four A granted, sold, and conveyed

all of its right, title, and interest in and to the equipment to

Black Mountain.   Four A retained a security interest in the

equipment as protection against nonpayment by Black Mountain.

     The agreement required Black Mountain to pay a total

purchase price of $445,000 for the equipment.    The purchase price

was to be paid monthly out of Black Mountain's production at a

rate of 17 cents per ton of coal produced in the preceding month.

     The agreement also provided that if Black Mountain failed to

make production payments, then the entire indebtedness became

immediately due and payable.   In such event, Black Mountain could

retain the equipment by paying the balance of the debt.    If Black

Mountain chose not to pay the remaining balance, it was required

to return the equipment to Four A.     The agreement provided that

the debt was nonrecourse.   In late 1995 or early 1996, Black

Mountain ceased making production payments and surrendered the

equipment to Four A.   The equipment was ultimately sold to a

third party.
                                - 5 -


       On its Form 1120S for 1993, Four A reported the transfer of

the equipment as a sale and reported the amount realized on the

sale as $445,000 (the total purchase price under the agreement).

This resulted in a section 1231 loss of $275,006.    In 1996, Four

A filed an amended Form 1120S which reported the amount realized

on the sale as $145,430.    This increased the section 1231 loss to

$574,576.    In 1996, petitioners filed Forms 1040X seeking refunds

for 1993 based on their pro rata shares of the increased section

1231 loss from Four A.

III.    Business Bad Debt Deduction

       From 1988 to May 6, 1991, Four A sustained substantial

losses, and Appolo advanced significant amounts of money to Four

A on a demand basis for the working capital needs of Four A (Four

A debt).    During 1993, G. Asher and L. Asher were shareholders of

Appolo, each owning 24 percent of its outstanding shares.    John

Asher, their father, was the majority shareholder of Appolo.

       In March 1991, Price Waterhouse LLP (PW) audited Appolo's

1990 financial statements.    During the audit, PW questioned the

collectability of the Four A debt and suggested that Appolo

establish a reserve against the Four A debt.    PW and S. Gaudiano,

acting in his capacity as the chief financial officer of Appolo,

reached an agreement whereby petitioners, acting in their

capacity as Four A shareholders, would execute guaranties to
                               - 6 -


Appolo for the Four A debt, and Appolo would not be required to

establish a reserve against the Four A debt.

      On or about May 13, 1991, petitioners executed two guaranty

agreements.   Both guaranties stated that they were supported by

adequate and sufficient consideration.   The first guaranty

covered all loans made by Appolo to Four A in the past and to be

made in the future.   The first guaranty stated that it was given

for good and valuable consideration and "as consideration for

Appolo not demanding immediate payment of its existing loans to

Four A and as an inducement to Appolo to make future advances to

Four A".

      At the time of Four A's bankruptcy in 1993, Four A owed

$1,106,000 to Appolo.   In 1993, Appolo wrote off the Four A debt

as a business bad debt under section 166 without ever demanding

payment from either Four A or the Four A shareholders.   As a

result, on their respective 1993 Federal income tax returns, G.

Asher and L. Asher each reported an ordinary loss of $80,246 as

their distributive share of Appolo's bad debt deduction.   During

1993, the Four A shareholders had the financial ability to honor

the guaranties, and they currently still have such ability.

                              OPINION

I.   Basis in Four A Stock

      Petitioners argue that they are entitled to increase their

bases of their Four A stock as a result of Four A's 1993
                                - 7 -


realization of COD income that was excluded under section 108(a).

After the initial briefs were filed by the parties, Nelson v.

Commissioner, 110 T.C. 114 (1998), was released by the Court.      In

his reply brief, respondent relies upon Nelson.     Petitioners do

not attempt to distinguish Nelson from the instant case but

instead assert that Nelson was incorrectly decided.

     In Nelson, we held that COD income realized and excluded

from gross income under section 108(a) does not pass through to

shareholders of an S corporation as an item of income in

accordance with section 1366(a)(1) so as to enable an S

corporation shareholder to increase the basis of his stock under

section 1367(a)(1).    We held in that case that section 108 is not

designed or intended to be a permanent exemption from tax.      Id.

at 125.   Excluded COD income is not "tax-exempt" pursuant to

section 1366(a)(1) and, thus, is not statutorily required to pass

through to the S corporation shareholders.    Id.

     We see no need to repeat our detailed analysis on this issue

contained in Nelson.    See Friedman v. Commissioner, T.C. Memo.

1998-196; Chesapeake Outdoor Enters., Inc. v. Commissioner, T.C.

Memo. 1998-175.   We hold, following Nelson, that the COD income

in the amount of $1,289,048 that Four A excluded from gross

income under section 108(a) is not a separately stated item of

tax-exempt income for purposes of section 1366(a)(1)(A).
                                - 8 -


Therefore, petitioners are not entitled to increase their bases

in the Four A stock due to Four A's COD income.

II.   Increased Section 1231 Loss

      In 1996, petitioners filed claims for refund for their

distributive shares of the increased section 1231 loss claimed by

Four A on its 1993 amended Form 1120S.    Respondent argues that

(1) the transaction was a lease and not a sale, and (2) if it was

a sale, the amount realized from the sale should be $445,000, the

amount originally reported by Four A on its return, instead of

$145,430 as reported by Four A on its amended return.

           A.   Sale v. Lease

      In 1993, Four A and Black Mountain executed a new agreement

concerning the equipment.   The agreement characterized the

transaction as a sale of the equipment.

      It is well settled that the economic substance of

transactions, rather than their form, governs for tax purposes.

Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1236

(1981).   In deciding whether a transaction constitutes a sale for

tax purposes, we consider whether the burdens and benefits of

ownership have passed to the purported purchaser.    See id. at

1237.   This is a question of fact to be ascertained from the

intentions of the parties as evidenced by the written agreements

read in the light of the attending facts and circumstances.     Id.

In ascertaining such intent, no single factor, or any special
                               - 9 -


combination of factors, is absolutely determinative.    Cal-Maine

Foods, Inc. v. Commissioner, T.C. Memo. 1977-89; see also Western

Contracting Corp. v. Commissioner, 271 F.2d 694 (8th Cir. 1959);

Benton v. Commissioner, 197 F.2d 745 (5th Cir. 1952); Haggard v.

Commissioner, 24 T.C. 1124 (1955), affd. per curiam 241 F.2d 288

(9th Cir. 1956).

     In Grodt & McKay Realty, Inc. v. Commissioner, supra at

1237-1238, we listed several factors considered by courts in

determining whether the benefits and burdens of ownership have

been transferred.   The factors considered were:

     (1) Whether legal title passes; (2) how the parties
     treat the transaction; (3) whether an equity was
     acquired in the property; (4) whether the contract
     creates a present obligation on the seller to execute
     and deliver a deed and a present obligation on the
     purchaser to make payments; (5) whether the right of
     possession is vested in the purchaser; (6) which party
     pays the property taxes; (7) which party bears the risk
     of loss or damage to the property; and (8) which party
     receives the profits from the operation and sale of the
     property. [Citations omitted.]

          1.   Whether Legal Title Passed

     We look to State law to determine whether a taxpayer has an

ownership interest in property.   See United States v. National

Bank of Commerce, 472 U.S. 713 (1985).    Under Kentucky law,

"title to goods passes * * * in any manner and on any conditions

explicitly agreed on by the parties."    Ky. Rev. Stat. Ann. sec.

355.2-401(1) (Michie 1996).   Petitioners argue that under the

agreement Four A granted, sold, and conveyed all of its right,
                                - 10 -


title, and interest in and to the equipment to Black Mountain.

Respondent argues that there is no evidence that legal title was

actually transferred to Black Mountain and points out that no

bill of sale was given to Black Mountain.

     The parties to the agreement designated that title passed

with the signing of the agreement, and under Kentucky law, the

parties' designation controls.     We conclude that legal title

passed to Black Mountain on the execution of the agreement.

          2.     How the Parties Treated the Transaction

     Four A recorded the transaction as a sale in its bankruptcy

filings and ceased taking depreciation deductions related to the

equipment after executing the agreement.       Respondent argues that

Black Mountain treated the transaction as a lease and relies on

the testimony of William Phipps, president of Black Mountain, for

this proposition.     Mr. Phipps testified that the transaction was

a "lease purchase" and not a sale.       However, during cross-

examination, Mr. Phipps admitted that he did not know the

difference between a lease purchase and a sale agreement and that

the purpose in executing the note was to gain ownership of the

equipment.     Mr. Phipps also conceded that his partner, Mr.

Donovan, did most of the negotiating with Four A regarding the

equipment.

     We find that the parties to the agreement treated the

transaction as a sale.
                                - 11 -


           3.   Other Factors

     The parties failed to present evidence regarding which party

bore the risk of loss or damage to the equipment.     Under the

agreement, Four A had a present obligation to convey title to

Black Mountain (as noted above), and Black Mountain had a present

obligation to make production payments to Four A in order to

retain the equipment.   Additionally, Black Mountain had

possession of the equipment.     Black Mountain was required to

return the equipment to Four A if it stopped making production

payments and failed to pay the remaining balance due under the

agreement.

           4.   Conclusion

     Based on our review of the relevant Grodt & McKay Realty

factors, we conclude that the transaction concerning the

equipment constituted a sale by Four A.

     B.   Amount Realized From the Sale

     On Four A's Form 1120S for 1993, Four A reported the amount

realized on the sale of the equipment as $445,000.     In 1996, Four

A filed an amended Form 1120S that reported the amount realized

on the sale as $143,430.     This increased Four A's section 1231

loss to $574,576.   Petitioners filed Forms 1040X seeking refunds

for 1993 based on Four A's increased section 1231 loss.3


     3
       We note that petitioners never received any response from
respondent regarding their amended Forms 1040X and that this
                                                   (continued...)
                              - 12 -


     Section 1001(b) provides that "The amount realized from the

sale or other disposition of property shall be the sum of any

money received plus the fair market value of the property (other

than money) received."   Petitioners argue that under section

1.1001-1(g)(2), Income Tax Regs., Four A was entitled to report

the amount realized on the sale as the present value of the

productions payments to be made under the agreement.

     In 1996, final regulations were issued providing a method

for calculating the amount realized from a contingent payment

debt instrument.   Sec. 1.1001-1(g)(2), Income Tax Regs.   Treasury

Decision 8674, explaining the final regulations, provides in

part:

          For a contingent payment debt instrument issued
     before August 13, 1996, a taxpayer may use any
     reasonable method to account for the debt instrument,
     including a method that would have been required under
     the proposed regulations when the debt instrument was
     issued. * * * [T.D. 8674, 1996-2 C.B. 84, 89.]

     The agreement for the sale of the equipment was executed in

1993, before the effective date of the 1996 regulations.

Petitioners contend, as we understand it, that Four A received,

in exchange for the equipment, a contingent payment debt

instrument within the meaning of the regulations.   Even if we



     3
      (...continued)
issue was not included in the statutory notices of deficiency or
in the petitions. We find that the issue was tried by consent
pursuant to Rule 41(b)(1), and we consider it to be before the
Court.
                               - 13 -


accept that premise arguendo, petitioners bear the burden of

proving that the method they used to compute the amount realized

was reasonable in light of the facts and circumstances.

       S. Gaudiano testified that he computed the amount realized

of $145,430 on Four A's amended Form 1120S using two different

methods:    (1) A balloon payment calculation using a normal

banking rate of 11-1/4 percent and (2) a junk bond calculation

using a 24- to 25-percent discount rate.    S. Gaudiano testified

that the two methods reached similar results.

       Neither Four A nor petitioners showed the present value

calculations on their amended returns, and during his testimony

S. Gaudiano failed to explain to the Court how either of his two

alleged methods arrived at an amount realized of $145,430.       From

the record, we are unable to discern the specific methodology

employed by S. Gaudiano in making the present value calculations.

Thus, petitioners have failed to establish that the method they

used to compute the amount realized of the note was reasonable or

had a basis in fact.    We conclude that petitioners have not

established that they are entitled to increase their section 1231

losses relating to the sale of the equipment by Four A.

III.    Bad Debt Deduction

       From 1988 to May 6, 1991, Appolo advanced significant

amounts of money to Four A for its working capital needs.      In

1991, petitioners, in their capacity as Four A shareholders,
                              - 14 -


executed two personal guaranty agreements that covered the debt

Four A owed to Appolo.   In 1993, Four A declared bankruptcy, and

Appolo wrote off the Four A debt and claimed a bad debt deduction

under section 166.   As a result, on their respective 1993 Federal

income tax returns, G. Asher and L. Asher each reported ordinary

losses of $80,246 as their distributive share of Appolo's bad

debt deduction.

     In the answer, respondent, for the first time, disallowed

these ordinary losses and asserted increased deficiencies in the

income taxes of G. Asher and L. Asher.    When a new matter is

pleaded in the answer, the burden of proof for that issue is on

respondent.   Rule 142(a).

     If Appolo is entitled to a bad debt deduction, then G. Asher

and L. Asher are entitled to ordinary losses related to their

distributive shares of the deduction.    Respondent argues that

Appolo is not entitled to a bad debt deduction under section 166

for the Four A debt because the Four A shareholders signed

personal guaranties and had the financial ability to repay the

Four A debt; therefore, the debt was not worthless as required

under section 166.   G. Asher and L. Asher argue that the

guaranties were not supported by adequate and sufficient

consideration and are not enforceable; therefore, the debt is

worthless, and Appolo is entitled to a bad debt deduction.
                              - 15 -


     On their face, the guaranties appear valid and enforceable.

Both guaranties stated, on their face, that they were supported

by adequate and sufficient consideration.   The first guaranty

stated that it was supported by two forms of consideration:    (1)

Appolo's promise not to demand immediate payment on past loans

made to Four A, and (2) Appolo's promise to make future loans to

Four A.4

     It is well settled under Kentucky law that forbearance to

sue is a sufficient consideration to support a promise.     Sellars

v. Jones, 175 S.W. 1002, 1003 (Ky. Ct. App. 1915).   The first

guaranty stated that Appolo promised to forbear suing Four A on

Four A's past debt; thus, the first guaranty was supported by

adequate and sufficient consideration and is enforceable.

     G. Asher and L. Asher argue that although the guaranty

recites that Appolo promised to forbear suing Four A on Four A's

past debt, Appolo never actually made such a promise to the Four

A shareholders.   The only evidence submitted by petitioners to

disprove the existence of that promise was their own self-serving

testimony.   Under these circumstances, we are not required to and

do not accept the self-serving testimony of petitioners.    See

Tokarski v. Commissioner, 87 T.C. 74 (1986).


     4
       By its terms, the first guaranty covers all loans made by
Appolo to Four A. If the first guaranty is enforceable, then the
debt is not worthless regardless of whether the second guaranty
is enforceable, and Appolo is not entitled to a bad debt
deduction for the debt.
                             - 16 -


     We conclude that the first guaranty was supported by

adequate and sufficient consideration and was enforceable.

Therefore, Appolo is not entitled to a bad debt deduction for the

Four A debt, and, accordingly, G. Asher and L. Asher are not

entitled to ordinary losses related to the bad debt deduction.

     To reflect the foregoing,

                                        Decisions will be entered

                                   under Rule 155.
