                               T.C. Memo. 2016-232



                         UNITED STATES TAX COURT



         BOBBY R. HARGIS AND BRENDA J. HARGIS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 14716-15.                          Filed December 21, 2016.



      Craig S. Lair and Betsy Turner, for petitioners.

      Ann Louise Darnold, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      COHEN, Judge: Respondent determined deficiencies of $153,782 and

$127,984 in petitioners’ Federal income tax for taxable years 2009 and 2010,

respectively. The issues for decision are: (1) whether Bobby Hargis (petitioner)

had sufficient basis in his S corporations to allow him to deduct the losses

generated by those entities in tax years 2007 through 2010; (2) if petitioner did
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[*2] have sufficient basis to deduct the losses, whether he materially participated

in the operations of the S corporations during the years in issue, so that the losses

passed through to him from the corporations should be treated as losses from

nonpassive activities; (3) if petitioner’s losses with respect to the S corporations

should be allowed as deductions and treated as nonpassive, whether the income or

losses of petitioner Brenda Hargis (Brenda Hargis), derived from her ownership

interests in several LLCs, should also be treated as nonpassive because the rental

activities of the LLCs may be grouped with the activities of the S corporations;

and (4) whether Brenda Hargis had sufficient basis in her ownership interests in

two of the LLCs to allow her to deduct her pro rata shares of losses from those

entities for tax years 2009 and 2010.

      Unless otherwise indicated, all section references are to the Internal

Revenue Code in effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.

                                FINDINGS OF FACT

      Some of the facts have been stipulated, and the stipulated facts are

incorporated in our findings by this reference. Petitioners resided in Arkansas at

the time they filed their petition.
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[*3] Background on Petitioners’ Businesses

      Petitioner and Brenda Hargis are a married couple who over the years have

earned a living by participating in various aspects of the nursing home industry.

During the years 2007 through 2010, petitioner was the 100% owner of several

Arkansas corporations whose primary business was the operation of nursing

homes (operating companies). Each of petitioner’s operating companies elected to

be treated as a small business corporation pursuant to section 1362.

      The operating companies themselves did not own any of the real property,

facilities, or equipment they used in operating the nursing homes. In the case of

each nursing home operation, these necessary assets were held by an LLC (nursing

home LLCs), which would lease them to petitioner’s operating company for a

monthly payment. Brenda Hargis was a 25% or less member in each of the

nursing home LLCs that rented property to petitioner’s operating companies and

in several others that owned and rented property to operating companies other than

petitioner’s.

      The role of the operating companies was to manage the day-to-day business

of running the nursing homes. For each nursing home petitioner hired a licensed

administrator to supervise and direct all operational aspects of the facility daily,

including patient admissions and discharges, patient billing, nursing services, food
                                        -4-

[*4] services, housekeeping, and facility upkeep and maintenance. Petitioner

spoke with the administrators at his facilities over the phone at least weekly, and

he held meetings quarterly with all the administrators he employed in a given

region. As owner of the operating companies, petitioner was consulted about and

approved all hiring decisions for key positions at the nursing homes, met with the

homes’ vendors and approved new vendor contracts, and approved all business

purchases that exceeded $500.

      Petitioner also personally visited the nursing homes operated by his

operating companies once or twice a month. Petitioner had past experience

working as a nursing home inspector for a State agency, and during his visits he

would physically walk through and inspect the facilities to ensure they met safety

standards. When petitioner found that maintenance repairs were needed, he would

order and oversee their completion. During his in-person visits petitioner would

also have conversations with and evaluate the performance of staff members,

check the quality of the food being served to patients, and review the businesses’

costs with the administrators.

      From 2007 to 2010, petitioner was also an employee of Cooper

Administrative Services (CAS). CAS was owned by Jim Cooper (Cooper), who

was also a member of the same nursing home LLCs as Brenda Hargis. CAS
                                        -5-

[*5] contracted with petitioner’s operating companies and was paid monthly a

fixed percentage of the nursing homes’ gross revenues to provide a range of

accounting, payroll, and billing and collection services to the businesses. CAS

provided these services to nursing home businesses other than petitioner’s and

also provided to such businesses information and guidance related to industry

trends, regulatory compliance, and risk management.

      Petitioner’s role was to serve as the “eyes and ears” for CAS on site at the

various facilities CAS contracted with, and in addition to visiting his own

operations over the course of the month petitioner would visit nursing homes run

by other operating companies. Petitioner was paid a salary by CAS all four of the

years in question, and he received no compensation from his operating companies

during those years. Later, petitioner ceased working for CAS and started receiving

wages from his own operating companies, probably beginning in 2012.

Business Model and Funding of the Nursing Home Businesses

      The business model subscribed to by the nursing home LLCs and their

members involved taking over rundown or distressed nursing home operations,

revamping their facilities and management, and transforming them into profitable

businesses. This strategy often required large, upfront capital outlays to be made

to renovate and in some cases reconstruct the nursing home facilities, and even
                                        -6-

[*6] once building was complete it took time to get the businesses running at a

profitable level. During these rebuilding periods cashflow into the businesses

would be greatly reduced. Thus the initial process of “restarting” a nursing home

would usually generate large net operating losses in at least the first one or two

taxable years following the nursing home LLC’s acquisition of the property.

      Petitioner’s operating companies lacked the working capital needed to begin

operating the businesses. To meet operating expenses at times when the

businesses suffered revenue shortfalls, petitioner’s operating companies relied on

numerous loans from various sources. For the five operating companies whose

losses are the subject of respondent’s notice of deficiency, Baxter County Nursing

Facility, Inc. (Baxter County), FCNRC, Inc. (FCNRC), Corning Therapy & Living

Center, Inc. (Corning), Rector Nursing & Rehab Center, Inc. (Rector), and

Osceola Therapy & Living Center, Inc. (Osceola), these loans fell into three

categories: (1) loans received from the nursing home LLCs in which Brenda

Hargis held an interest (and, in the case of one of the operating companies, loans

received from an individual nursing home LLC member) (LLC loans), (2) loans

received from petitioner’s other operating companies (intercompany loans), and

(3) loans received from banks or institutions having no connection with petitioner

or the LLCs (commercial loans).
                                        -7-

[*7] For all of the LLC loans and intercompany loans, and for some of the

commercial loans, petitioner signed the notes evidencing the loans in his

individual capacity as a coborrower along with his operating companies. With

respect to these loans petitioner signed on as a coborrower, proceeds were

advanced directly by the lending entity to the coborrowing operating company. To

the extent payments became due on such loans, they were made by the operating

companies and not out of petitioner’s personal account.

      The LLC notes and intercompany notes all took the same “short form” and

all provided for a term of seven years and an interest rate of 0%. An oral

agreement existed between petitioner and the members of the nursing home LLCs

that the LLCs would lend funds to the operating companies if extra cash was

needed to meet the businesses’ operating expenses and the LLCs had sufficient

cash reserves on hand. Petitioner himself made decisions to move funds from one

operating company to another; and he reviewed the relative cashflows of his

companies several times a month to determine when and where such loans were

necessary to keep all operations running smoothly.

      Most of the loans received by the five operating companies named above

during the years in issue were either LLC loans or intercompany loans. The

majority of the LLC loans and intercompany loans were for amounts less than
                                         -8-

[*8] $100,000, and the proceeds of these loans were used primarily by the

borrowing companies to meet basic operating expenses. Each of the operating

companies also entered into at least one commercial loan arrangement with a

lender unrelated to either petitioner or the LLCs. All of the commercial notes bore

an agreed-upon rate of interest and called for periodic payments.

      The table below gives a summary of the commercial loans for which

petitioner’s operating companies were coborrowers:

  Lender          Borrower(s)        Petitioner        Date                 Amount


 Universal       Baxter County      Coborrower      October 2007            $183,470
  Reinsurance
  Co.            Baxter County      Coborrower      July 2009                372,035
                 FNCRC              Coborrower      October 2007             131, 821
                 FNCRC              Coborrower      July 2009                 94,158
 Farmer’s Bank   Osceola (w/ one    Guarantor       December 2010          4,071,925
  & Trust Co.     nursing home
                  LLC)
 Bank of         Corning & Rector   Guarantor       August 2009      1,280,000
  Oklahoma        (w/ two other                                      term loan, w/
                  operating                                          construction
                  companies &                                        loan not to
                  three nursing                                      exceed
                  home LLCs)                                         3,360,000

Borrowing by the Nursing Home LLCs

      The nursing home LLCs would also on occasion borrow or coborrow funds,

generally for the purchase of the real property and facilities that would be used for
                                         -9-

[*9] the nursing home businesses. Brenda Hargis was a member of Melbourne

Properties, LLC (Melbourne Properties), which received a loan of $2 million from

Liberty Bank of Arkansas (Liberty Bank) in December 2005. Brenda Hargis,

petitioner, and four other individuals signed guaranty agreements as security for

the Liberty Bank loan. The Liberty Bank loan agreement did not state that the

loan would be recourse debt as to individual members of Melbourne Properties.

      The Forms 1065, U.S. Return of Partnership Income, filed by Melbourne

Properties for the tax years 2007, 2008, and 2009 did not report the amount of

partnership liabilities existing at the end of each of those tax years and did not

include analysis of partners’ capital accounts. The Schedules K-1, Partner’s Share

of Income, Deductions, Credits, etc., issued to Brenda Hargis for 2007 through

2009 did not report the amount of her share of partnership liabilities at yearend or

give an analysis of her capital account at yearend.

      Brenda Hargis was also a member of Clay County, LLC (Clay County),

which was one of seven coborrowers on a loan from Bank of Oklahoma in August

2009. The Bank of Oklahoma loan proceeds were for the purchase of the Corning

nursing home property by Clay County and for the construction of a new facility

on that property. The agreement did not state whether or how responsibility for

the indebtedness was to be apportioned among the seven entities listed as
                                       - 10 -

[*10] coborrowers. Brenda Hargis, petitioner, and two other individuals signed as

guarantors of the Bank of Oklahoma loan. The Bank of Oklahoma loan was not

described in the loan agreement as being recourse, and the remedies provided for

upon default did not include actions against individual members or shareholders of

any of the borrowing entities.

       The Form 1065 filed by Clay County for 2009 reported partnership

liabilities from “Mortgages, notes, bonds payable in 1 year or more” equaling

$2,531,196 and gave an analysis of partners’ capital account balances. The

Schedules K-1 issued to Brenda Hargis from Clay County for 2009 and 2010

provided calculations of Brenda Hargis’ capital account at the end of the taxable

years. The Schedules K-1 did not report the amount of her share of partnership

liabilities for those years.

Losses Reported on Petitioners’ Returns and the Notice of Deficiency

       A number of petitioner’s operating companies, including the five named

above, reported net operating losses for the taxable years ending December 31,

2007, 2008, 2009, and 2010. These losses were passed through and reported by

petitioners on their jointly-filed Forms 1040, U.S. Individual Income Tax Return,

for those same tax years. In calculating the losses he reported with respect to the

operating companies, petitioner each year claimed an increased tax basis in the
                                       - 11 -

[*11] indebtedness of the operating companies on the basis of his position as

coborrower, and in some instances guarantor, of the loans received by the

companies. The attached Schedules E, Supplemental Income or Loss, Part II,

Income or Loss from Partnership and S Corporations, reported the losses from

petitioner’s operating companies as losses from nonpassive activities.

      Several of the nursing home LLCs also reported net operating losses for tax

years 2007 through 2010. Brenda Hargis’ pro rata shares of the LLC losses were,

most often, also reported on petitioners’ Schedules E as nonpassive losses.

Petitioners reported on their joint returns losses from Melbourne Properties for

2007, 2008, and 2009, and from Clay County for 2009 and 2010.

      With their 2008 joint return petitioners began reporting a net operating loss

carryover as part of “Other Income”, reported on line 21 of their Forms 1040. For

2009 and 2010, the years to which respondent’s notice pertains, petitioners

claimed deductions for net operating loss carryovers of $637,523 and $819,772,

respectively.

      On March 12, 2015, respondent issued a notice of deficiency proposing total

adjustments of $1,382,206 and $1,900,898 to petitioners’ taxable income for the

years 2009 and 2010, respectively. Respondent determined that petitioners’

claimed deductions for net operating loss carryovers should be completely
                                         - 12 -

[*12] disallowed for both years 2009 and 2010 on the basis of his finding that

petitioners improperly reported certain losses arising from their business activities

for 2007 and 2008. Respondent determined petitioner was not entitled to increase

his basis in the indebtedness of the operating companies because of his

participation as coborrower or guarantor of the above-described loans, and for that

reason respondent determined petitioner lacked sufficient basis to deduct the

operating companies’ losses for 2007 and 2008. Additionally, respondent

determined petitioners were not entitled to deduct the 2007 and 2008 passthrough

losses they reported from Brenda Hargis’ interest in Melbourne Properties,

because petitioners had failed to establish that Brenda Hargis had sufficient basis

in her interest for those losses to be deductible.

      Respondent next determined several adjustments to petitioners’ Schedules E

for the tax years 2009 and 2010. Again, respondent determined petitioner could

not increase his basis by the loans received by the operating companies, and

claimed losses attributable to those entities for 2009 and 2010 were reduced by

respondent, in most cases to zero. Respondent also determined petitioners had

failed to show that Brenda Hargis had a sufficient basis in her interest in

Melbourne Properties to allow them to deduct her pro rata share of loss from that

entity for 2009. Lastly, respondent determined that a loss reported by petitioners
                                        - 13 -

[*13] for 2010 from Brenda Hargis’ interest in Clay County should be reduced

since petitioners had similarly failed to establish that Brenda Hargis’ basis in that

entity was sufficient to allow a deduction of the full amount.

      The last major adjustment determined by respondent in the notice of

deficiency involved the characterization of petitioners’ income and losses derived

from the nursing home LLCs. For taxable years 2009 and 2010, all income and

losses from the LLCs in which Brenda Hargis owned interests were

recharacterized by respondent as income or losses from passive activities because

the nursing home LLCs conducted only rental activities.

      Respondent also determined at the time the notice was issued that petitioner

did not materially participate in the operations of the operating companies.

However, in exhibits attached to the notice of deficiency, respondent did not

recharacterize any of the income or losses that were not disallowed.

                                      OPINION

Petitioner’s Basis in the Indebtedness of the Operating Companies

      Section 1366(a)(1) provides a shareholder of an S corporation shall take

into account his pro rata share of the S corporation’s items of income, loss,

deduction or credit for the S corporation’s taxable year ending with or in the

shareholder’s taxable year. Section 1366(d)(1) limits the amount of losses and
                                       - 14 -

[*14] deductions the shareholder may take into account for any taxable year to the

sum of his adjusted basis in the stock of the S corporation plus his adjusted basis

in “any indebtedness of the S corporation to the shareholder”. Sec. 1366(d)(1)(B).

Any losses so disallowed may be carried forward indefinitely. See sec.

1366(d)(2).

      Section 1366(d)(1) ensures that a shareholder may not deduct expenses of

the S corporation beyond the extent of his personal investment in the corporation.

Bergman v. United States, 174 F.3d 928, 931 (8th Cir. 1999). Thus courts have

consistently held that to increase his basis in an S corporation a shareholder must

make an “actual economic outlay”. Id. at 930 n.6 (citing Perry v. Commissioner,

54 T.C. 1293, 1295-1296 (1970), aff’d, 1971 WL 2651 (8th Cir. 1971)). Any

claimed increase in a shareholder’s basis must be based on “some transaction

which when fully consummated left the taxpayer poorer in a material sense.”

Perry v. Commissioner, 54 T.C. at 1296 (quoting Horne v. Commissioner, 5 T.C.

250, 254 (1945)).

      Generally then, section 1366(d)(1)(B) contemplates a direct loan by the

shareholder to the corporation using his own funds, or at least using funds for

which he will be held ultimately responsible. Oren v. Commissioner, T.C. Memo.

2002-172, aff’d, 357 F.3d 854, 858 (8th Cir. 2004). This Court has found that
                                        - 15 -

[*15] basis can be created where a shareholder borrows funds from a third party

and then uses those funds to make a loan to the corporation (a “back-to-back”

loan). See Raynor v. Commissioner, 50 T.C. 762, 771 (1968); Miller v.

Commissioner, T.C. Memo. 2006-125, 2006 WL 1652681, at *7 (citing Bolding v.

Commissioner, 117 F.3d 270 (5th Cir. 1997), rev’g T.C. Memo. 1995-326). The

shareholder can also increase his basis in the corporation by lending money that he

has borrowed from another wholly owned entity, although in such a case the

arrangement is eyed with scrutiny and the taxpayer bears the burden of

demonstrating that a genuine indebtedness was created between himself and the

related entity. See Oren v. Commissioner, 357 F.3d at 858; Yates v.

Commissioner, T.C. Memo. 2001-280.

      In any event, it is well settled that for basis to be created for a shareholder

under section 1366(d)(1)(B), the corporation’s indebtedness must run “directly to

the shareholder.” Prashker v. Commissioner, 59 T.C. 172, 176 (1972). No basis is

created for a shareholder when funds are advanced to an S corporation by a

separate entity, even one closely related to the shareholder. Bergman, 174 F.3d at

932. As is often said, “[n]o form of indirect borrowing, be it guaranty, surety,

accommodation, comaking or otherwise, gives rise to indebtedness from the

corporation to the shareholders until and unless the shareholders pay part or all of
                                         - 16 -

[*16] the obligation. Prior to that crucial act, ‘liability’ may exist, but not debt to

the shareholders.” Raynor v. Commissioner, 50 T.C. at 770-771.

      In this case, the loan transactions were structured so that the indebtedness of

petitioner’s operating companies ran directly from the operating companies to the

lending entities. For all the loans at issue the proceeds were advanced directly by

the lending entities to the operating companies, and the notes executed by the

operating companies were payable to entities separate from petitioner. On the face

of the notes the operating companies are not indebted to petitioner for anything;

rather, petitioner is listed as a coborrower, and in some instances, a guarantor.

Perhaps acknowledging that the notes themselves evidence no “indebtedness of

the S corporation[s] to the shareholder”, see sec. 1366(d)(1)(B) (emphasis added),

petitioners emphasize the extent of petitioner’s personal liability for the borrowed

sums. In particular, petitioners point to the fact that petitioner signed individually

as a coborrower on all of the intercompany and LLC loans received by his

operating companies, as well as on the four Universal Reinsurance Co. notes.

      Petitioners argue that under Arkansas State law a coborrower is “directly

liable” for repayment and that his liability “is the same as if the loan were made to

the borrower individually.” Petitioners believe that the assumption of

coborrower’s liability, which they say put “[petitioner’s] own funds * * * at risk”,
                                        - 17 -

[*17] amounts to an economic outlay by petitioner that should be treated, in effect,

as indebtedness of the operating companies to him. This is, however, the

reasoning that has been rejected by this Court and others in prior cases. Those

cases make clear that the bare potential for liability, without more, will not be

considered a real economic outlay by a shareholder. See, e.g., Estate of Leavitt v.

Commissioner, 90 T.C. 206, 211-212 (1988), aff’d, 875 F.2d 420 (4th Cir. 1989);

Underwood v. Commissioner, 63 T.C. 468, 475-476 (1975), aff’d, 535 F.2d 309

(5th Cir. 1976); Perry v. Commissioner, 47 T.C. 159, 163-164 (1966), aff’d, 392

F.2d 458 (8th Cir. 1968); Estate of Bean v. Commissioner, T.C. Memo. 2000-355,

2000 WL 1706714, at *2-*3, aff’d, 268 F.3d 553 (8th Cir. 2001).

       The record reveals that petitioner was never himself subjected to the burden

of paying back the amounts borrowed by his operating companies. Petitioner

testified at trial that there were no defaults on the loans and that he was never

called on to make any payments on the loans personally. To the extent payments

were made, they were made by the operating companies directly back to the

lenders. Any interest paid by the operating companies on the indebtedness

presumably was not reported as constructive dividends to petitioner. Petitioner

never pledged any of his personal property as collateral for the amounts borrowed

by his companies.
                                        - 18 -

[*18] As coborrower, petitioner could theoretically have been required to make

payments to the lenders when they became due, and in such a case it would be

possible to say that petitioner’s payments subrogated him to the rights of the

original lender; in that case, the operating company would be directly indebted to

him. However, petitioner was never so required. So long as petitioner’s personal

liability remained only potential, it would be incorrect to say he made an economic

outlay that left him “poorer in the material sense.” The debts of the operating

companies when they were incurred ran from the borrowing companies to the

lending entities, and at no point did petitioner interpose himself between the

parties.

       Petitioners also rely on the case Selfe v. United States, 778 F.2d 769 (11th

Cir. 1985), for the proposition that a shareholder’s guaranty or comaking of a

third-party loan to the corporation should be treated as an investment by the

shareholder in the corporation where “the lender looks to the shareholder as the

primary obligor.” Petitioners ask us to view petitioner’s comaking and guaranty

arrangements constructively as back-to-back loans from the lenders to petitioner

and from petitioner to the operating companies.

       The “substance over form” argument advanced by petitioners here has been

mostly rejected by this Court in past cases. See, e.g., Estate of Leavitt v.
                                        - 19 -

[*19] Commissioner, 90 T.C. at 212; Frankel v. Commissioner, 61 T.C. 343

(1973), aff’d, 506 F.2d 1051 (3d Cir. 1974); Shebester v. Commissioner, T.C.

Memo. 1987-246, 1987 WL 40297. A showing that the lending entity was used by

the taxpayer as his “incorporated pocketbook” has been recognized in some cases.

See Yates v. Commissioner, T.C. Memo. 2001-280; Culnen v. Commissioner, T.C.

Memo. 2000-139, rev’d on another issue, 28 F. App’x 116 (3d Cir. 2002). The

Court in Selfe, 778 F.2d at 773, recognized that “taxpayers ordinarily are bound by

the ‘form’ of their transaction and may not argue that the ‘substance’ of their

transaction triggers different tax consequences.” See also Don E. Williams Co. v.

Commissioner, 429 U.S. 569, 579 (1977); Commissioner v. Nat’l Alfalfa

Dehydrating & Mining Co., 417 U.S. 134, 149 (1974). Especially where the

entities involved in a transaction are each wholly owned by the taxpayer, the

taxpayer bears a heavy burden of demonstrating that the substance of the

transaction differs from its form. Ruckriegel v. Commissioner, T.C. Memo. 2006-

78, 2006 WL 1007628, at *8 (citing Bergman, 174 F.3d at 933).

      In the case at hand none of the proceeds of the loan agreements entered into

by petitioner and his operating companies were ever advanced to petitioner

individually. We think this distinction is critical. What initially happened in Selfe

was a loan to the taxpayer directly, the proceeds of which she used to invest in her
                                         - 20 -

[*20] fledgling business. Selfe, 778 F.2d at 770. Only after that back-to-back

transaction had taken place did the bank insist that the taxpayer refinance the line

of credit in the name of the business. Id. at 770-771. Even then the Court of

Appeals remanded the taxpayer’s case to the District Court for additional factual

findings on the issue of “whether or not the bank primarily looked to * * * [the

taxpayer] for repayment”. Id. at 775.

      None of the notes petitioner signed as coborrower or guarantor were

collateralized by petitioner’s own property. The pledge of personal assets, which

the Court found to be specially indicative of a real outlay by the taxpayer in Selfe,

was not made by petitioner here. See id. at 772 n.7. Although petitioners claim on

brief that “all of * * * [petitioner’s] assets served as security” because “the

practical effect of the pledge of his individually owned property versus signing an

obligation to repay the loans individually is the same”, they have cited no legal

authority supporting this assertion.

      Lastly, petitioners provided no convincing evidence that any of the lenders

looked to petitioner as the primary obligor on the loans received by the operating

companies. This is especially true with respect to the LLC loans and the

intercompany loans, which generally lacked the indicia of genuine indebtedness.

The LLC and intercompany loans had no interest rates and no repayment
                                         - 21 -

[*21] schedules, and from the record it appears likely that most of these loans were

never actually repaid.

      Petitioner testified that regular payments were generally not made on the

LLC and intercompany notes; instead, payment was deferred until the end of the

seven-year term, “since there was no interest involved.” Petitioners disposed of

their interests in the operating companies and the nursing home LLCs sometime in

2014, probably in May, by selling them to another nursing home LLC member,

Cooper. Petitioners’ sale preceded the date that payment became due for the great

majority of the LLC and intercompany notes. In arriving at a sales figure for

petitioners’ interests, Cooper testified that he factored in the amounts still

outstanding on the various LLC and intercompany loans, along with “other

liabilities involved”, and ultimately he said he “basically assumed these liabilities

and forgave * * * [petitioner] those loans personally, and basically considered

them to be paid off upon my purchase of all his stock.”

      Petitioner could not personally confirm that any of the LLC loans or

intercompany loans were paid off during his time as owner of the operating

companies. From the evidence it seems that no demand for payment was ever

made on the operating companies with respect to these loans; certainly no demand

for payment was ever made on petitioner personally.
                                       - 22 -

[*22] With respect to the Universal Reinsurance Co. loans that petitioner signed

as coborrower, petitioners provided no evidence regarding the making of those

loans that suggests Universal Reinsurance Co. considered petitioner, rather than

his operating companies, to be the one primarily responsible for making interest

and principal payments. Petitioner was never required to make payments on the

Universal Reinsurance Co. loans from his personal account. Petitioner disposed of

his interests in the operating companies shortly before the principal amounts on

the first set of Universal Reinsurance Co. notes became due. These principal

payments apparently were part of the liabilities assumed by Cooper upon his

purchase of petitioner’s stock.

       Nor can we conclude that the banks considered petitioner to be the primary

obligor on the Farmer’s Bank & Trust and Bank of Oklahoma loans that he signed

as a guarantor. We accept petitioners’ assessment that these large loans would not

have been made but for petitioners’ personal creditworthiness and their

willingness to sign personal guaranties. However, petitioners were not the only

guarantors of either the Farmer’s Bank & Trust loan or the Bank of Oklahoma

loan. And in any case, that a loan would not have been made to a corporation but

for a shareholder’s personal creditworthiness and guaranty of repayment does not

in itself indicate that the bank looked to the shareholder for repayment (or
                                         - 23 -

[*23] necessitate the conclusion that the shareholder made an outlay in providing

that guaranty). See, e.g., Sleiman v. Commissioner, 187 F.3d 1352, 1358 (11th

Cir. 1999), aff’g T.C. Memo. 1997-530; Estate of Leavitt v. Commissioner, 90

T.C. at 215; Brown v. Commissioner, T.C. Memo. 1981-608, 1981 WL 11008.

      Petitioner’s operating companies were not the only borrowers for the

Farmer’s Bank & Trust and Bank of Oklahoma loans, and we think the operating

companies were not the primarily indebted co-borrower in the case of either. The

proceeds of both loans went towards the purchase of real property by a co-

borrowing LLC and were not used by petitioner’s operating companies to operate

the nursing homes. Indeed, with respect to the Bank of Oklahoma loan,

petitioners’ witness Cooper testified that the entire balance of that indebtedness

“should have been allocated to Clay County [LLC]”. If we accept that statement

as true, then the issue of whether the bank considered petitioner to be the primary

obligor is irrelevant, because there was no “indebtedness of the S corporation[s]”

that could create shareholder basis for petitioner in the first place.

      Petitioner’s companies were thinly capitalized, and we accept that at least

some of the lenders wanted petitioner, with his substantial assets, to be liable for

repayment in the event the businesses failed. If the lenders specifically wanted

petitioner to be the primary obligor on the loans (and, for that matter, if petitioner
                                       - 24 -

[*24] himself wanted to fill that role), then the transactions could have been

structured by agreement of the parties so that proceeds were lent directly to

petitioner and then contributed by petitioner to the operating companies. The

lenders, if they expected petitioner to be primarily and personally responsible for

repayment, might have insisted on a pledge of his personal assets as security.

      Absent some other evidence demonstrating that the lenders treated

petitioner as the primary obligor on the loans he cosigned or guaranteed, we

cannot conclude that petitioners’ case fits within Selfe’s narrow exception to the

general rule that the indebtedness of the S corporation must run directly to the

shareholder for that indebtedness to increase the shareholder’s basis in the S

corporation under section 1366(d)(1)(B). We decline to recast the form of the loan

transactions entered into by petitioner’s operating companies to align with what

petitioners now allege are their underlying substance. To the extent genuine

indebtedness was created, we believe in this case that “the substance matched the

form”. Harris v. United States, 902 F.2d 439, 442 (5th Cir. 1990) (quoting Brown

v. Commissioner, 706 F.2d at 756).

      Because the form of the transactions shows the indebtedness existed directly

between the operating companies and the lenders, and because petitioners have not

shown that the substance of those transactions should be viewed differently from
                                       - 25 -

[*25] their form, we conclude that petitioner’s role as comaker or guarantor of the

operating companies’ notes did not entitle him to claim basis in the indebtedness

of the operating companies under section 1366(d)(1). We uphold respondent’s

determination that petitioners improperly reported the losses arising from certain

of the operating companies owned by petitioner during the taxable years 2007,

2008, 2009, and 2010. We sustain all adjustments made by respondent on the

basis of that determination.

      Because we find respondent was correct in disallowing deductions for the

operating companies’ losses reported by petitioners during 2007 through 2010, it

is unnecessary to decide whether those losses were losses from passive or

nonpassive activities. Therefore we do not consider the issue of whether

petitioner “materially participated” in the operations of the operating companies.

We also do not consider whether petitioners properly could have grouped the

activities of the nursing home LLCs with the activities of the operating companies

under section 1.469-4(d)(1), Income Tax Regs., for the purposes of determining

the character and amount of income or losses attributable to those activities for the

years in issue.
                                         - 26 -

[*26] Petitioner Brenda Hargis’ Basis in Melbourne Properties and Clay County

      LLCs

      The only issue left for our consideration is whether Brenda Hargis had

sufficient basis in her membership interests in two of the nursing home LLCs to

allow petitioners to deduct losses from those entities for tax years 2007 through

2010. Respondent disallowed deductions for petitioners’ reported losses from

Melbourne Properties for the tax years 2007, 2008, and 2009 and a portion of a

deduction for a loss from Clay County for 2010. Respondent’s determination was

that petitioners had not submitted adequate documentation establishing Brenda

Hargis’ basis in these two entities.

      Under applicable regulations, LLCs such as the nursing home LLCs in

which Brenda Hargis held interests are treated the same as partnerships for Federal

tax purposes. See sec. 301.7701-3(a), Proced. & Admin. Regs. A deduction for a

partner’s distributive share of partnership losses is allowed only to the extent of

the adjusted basis of the partner’s interest in the partnership at the end of the

partnership year in which such loss occurred. Sec. 704(d). Any increase in a

partner’s share of liabilities of the partnership is considered a contribution by the

partner to the partnership and, consequently, increases the basis of the partner’s
                                        - 27 -

[*27] interest in the partnership. See secs. 722, 752(a); sec. 1.752-1(b), Income

Tax Regs.

      Petitioners provided evidence of the Liberty Bank loan and the Bank of

Oklahoma loan, which they contend supports a finding that Brenda Hargis had

sufficient basis in Melbourne Properties and Clay County, respectively, for

petitioners to report and deduct her pro rata shares of losses from those LLCs for

all the years in issue. Forms 1065 filed by Melbourne Properties and Clay County

and Schedules K-1 issued to Brenda Hargis from the two LLCs were also

provided.

      We did not discuss the burden of proof with respect to petitioner’s basis in

the operating companies because the evidence was sufficient to determine by a

preponderance that the borrowing did not qualify as a primary obligation or

economic outlay by petitioner. On the matter of Brenda Hargis’ basis, however,

petitioners’ evidence is not sufficient to prove her basis or to shift the burden of

proof to respondent under section 7491(a).

      Generally, petitioners bear the burden of proving that the adjustments set

forth in respondent’s notice of deficiency were erroneous. See Rule 142(a); Welch

v. Helvering, 290 U.S. 111 (1933). Specifically, petitioners must prove their

entitlement to deductions. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
                                        - 28 -

[*28] (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

Petitioners bear the burden of maintaining the records needed to establish their

entitlement. See sec. 6001; Hradesky v. Commissioner, 65 T.C. 87 (1975), aff’d,

540 F.2d 821 (5th Cir. 1976). In order to prove they were entitled to deduct the

nursing home LLC losses disallowed by respondent, petitioners must establish

with specificity Brenda Hargis’ basis in Melbourne Properties and Clay County.

See sec. 704(d); O’Neill v. Commissioner, 271 F.2d 44, 50 (9th Cir. 1959) (“Proof

of basis is a specific fact which the taxpayer has the burden of proving.”), aff’g

T.C. Memo. 1957-193.

      Petitioners have not provided any numeric computations of Brenda Hargis’

basis in Melbourne Properties and Clay County for the years in issue. The Forms

1065 filed by Melbourne Properties and the Schedules K-1 issued to Brenda

Hargis from Melbourne Properties for 2007 through 2009 do not report the total

amount of partnership liabilities existing in those years and do not report the

amount of partnership liabilities allocated to her. The Form 1065 for Clay County

for 2009 does report some partnership liabilities, but a Form 1065 for Clay County

for 2010 was not provided, and the Schedule K-1 issued to Brenda Hargis from

Clay County for 2010 does not report the amount of her share of partnership

liabilities. None of these tax forms stipulated by the parties establishes that
                                        - 29 -

[*29] Brenda Hargis had an increased tax basis in her membership interests on

account of shares of the LLCs’ liabilities.

      Petitioners introduced copies of the Liberty Bank and Bank of Oklahoma

loan agreements, and they argue that some shares of those liabilities would have

been allocable to Brenda Hargis as a member of Melbourne Properties and Clay

County, respectively. We find the existence of the loan agreements establishes at

most that the nursing home LLCs incurred some amount of liabilities in the years

those loans were made. Petitioners provided no further documentary evidence

explaining how and to what extent the two loans affected Brenda Hargis’ basis in

the two entities. Petitioners provided nothing that definitively shows what

adjustments, if any, were made to Brenda Hargis’ basis in the years of the loans or

in the subsequent years leading up to the disallowed losses.

      Petitioner’s witness Cooper testified that liabilities of the nursing home

LLCs were allocated among members according to their ownership percentages,

and this generally supports the assertion that Brenda Hargis should have been

allocated some share of LLC liabilities on the basis of the Liberty Bank and Bank

of Oklahoma loans. However, the mere presence of the loan agreements and such

generalized testimony do not allow us to determine Brenda Hargis’ correct basis in

her membership interests for the years in issue. Petitioners’ evidence is simply too
                                       - 30 -

[*30] incomplete to establish basis amounts for Brenda Hargis’ interests in the two

nursing home LLCs.

      To the extent that Brenda Hargis’ basis has not been adequately established,

respondent is justified in treating it as zero. See Rule 142(a); Welch v. Helvering,

290 U.S. 111. We agree with respondent that petitioners have not met their

burden of proving that they were entitled to deduct the losses from Melbourne

Properties and Clay County that respondent disallowed in the notice of deficiency.

      We have considered all arguments made, and, to the extent not mentioned,

we conclude that they are moot, irrelevant, or without merit. To reflect the

foregoing,

                                                Decision will be entered

                                       for respondent.
