                          T.C. Memo. 2001-280



                      UNITED STATES TAX COURT



         CHARLES E. AND JACQUELYN YATES, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 5386-00, 8504-00.          Filed October 11, 2001.


     Bruce M. Reynolds and Ashley W. Ward, for petitioners.

     Michael D. Zima, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     FOLEY, Judge:   By notices dated February 9 and June 23,

2000, respondent determined deficiencies in petitioners’ 1994,

1995, and 1996 Federal income taxes of $237,945, $457,955, and

$172,586, respectively.    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
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Procedure.   After concessions, the issue remaining for

determination is whether certain transfers from Adena Fuels, Inc.

(Adena), to Fox Trot Corp. (Fox Trot), increased petitioners’

basis in Fox Trot.

                          FINDINGS OF FACT

     Charles and Jacquelyn Yates (petitioners) resided in

Clearwater, Florida, when they filed their petition.

     During 1993 through 1996, Mr. Yates was the sole

shareholder, officer, and director of several mining and mining-

related corporations (mining companies), including Adena, an S

corporation, and Adena Processing Company (Adena Processing),

operating in Eastern Kentucky.    Mrs. Yates is not, and has never

been, a shareholder, officer, or director of any of the mining

companies.

     From 1993 through 1996, Mr. Yates employed Larry Adams, a

certified public accountant.   Mr. Adams kept the books for

petitioners and their companies.    Because of Mr. Yates’ frequent

unavailability, Mr. Adams had the authority to sign Adena’s

checks.

     From 1993 through 1996, petitioners wrote 409 checks on

Adena’s account, totaling $1,831,156, for various personal

expenses.    In addition, at Mr. Yates’ direction, Adena personnel

wrote 113 checks, totaling $2,231,248, to or for petitioners.

These payments were charged to Mr. Yates’ accumulated adjustments
                                 - 3 -

account and treated as dividends from Adena, reducing his basis

in Adena’s stock.    Mr. Adams knew about and acquiesced to

petitioners’ practice of paying personal expenses with funds from

the Adena account.

     Mr. Yates personally guaranteed a large amount of debt

relating to the mining companies (mining debt) and was concerned

about the likelihood of personal injury lawsuits relating to

employees of such companies.    In an attempt to protect some of

his assets from these risks, and to provide a mechanism to

accumulate assets for retirement, on December 16, 1992, Mr. Yates

incorporated Fox Trot as an S corporation.    Through Fox Trot

petitioners purchased, improved, and operated a Kentucky farm.

Mr. Yates kept Fox Trot’s assets and liabilities separate from

those of the mining companies.

     From January 1, 1993, until September 1, 1994, Mr. Yates was

the sole shareholder of Fox Trot.    On September 1, 1994, to

further separate Fox Trot’s assets from the mining companies’

risk, Mr. Yates gave all of Fox Trot’s stock to Mrs. Yates, who

was the sole shareholder of Fox Trot from September 1, 1994,

through 1996.

     During the years in issue, Fox Trot experienced substantial

losses.   Mr. Yates used funds from Adena to finance Fox Trot.
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Pursuant to Mr. Yates’ direction, Mr. Adams transferred funds

from Adena to Fox Trot and recorded the transactions as follows1:

           Date         Amount        Adena’s Books           Fox Trot’s Books

1993                  $1,920,112   Distribution to Mr.     Contribution to capital
                                   Yates

1993                       1,037   Accumulated             Contribution to capital
                                   Adjustments Account

Jan. 1 through           853,557   Loans to Mr. Yates      Accounts Payable – Mr.
Sept. 1, 1994                                              Yates

Sept. 1 through          415,279   Loans to Mr. Yates      Accounts Payable – Mr.
Dec. 31, 1994                                              Yates

Jan. 1 through Oct.      293,360   Accounts Receivable –   Accounts Payable - Yates
15, 1995                           Yates

Jan. 1 through Oct.      543,447   Accumulated             Accounts Payable - Yates
15, 1995                           Adjustments Account


       A loan agreement entered in 1994 relating to the mining debt

limited Mr. Yates’ dividends from Adena to 90 percent of Adena’s

earnings, but did not restrict his ability to borrow from Adena.

In response, Mr. Yates directed Mr. Adams to change the posting

procedure, beginning on October 1, 1994, so that subsequent

transfers of funds from Adena to Fox Trot were posted as either

distributions or loans from Adena to Mr. Yates and as either

capital contributions or loans from Mr. Yates to Fox Trot.                       Mr.

Adams recorded, in Adena’s books, the 1995 transfers of funds


       1
      From 1993 through Sept. 30, 1994, Mr. Adams initially
recorded transfers in the “Due to/from Fox Trot” account of
Adena’s books, and the “Due to/from Adena” account in Fox Trot’s
books. Mr. Adams, at the end of 1993, reposted the 1993
transfers in Adena’s books as distributions or loans from Adena
to Mr. Yates and in Fox Trot’s books as contributions to capital.
Similarly, prior to the end of 1994, Mr. Adams posted the 1994
transfers in Adena’s books as loans to Mr. Yates and in Fox
Trot’s books as accounts payable to (i.e., loans from) Mr. Yates.
                               - 5 -

from Adena to Fox Trot as accounts payable to (i.e., loans from)

petitioners.

     On December 31, 1994, Mr. Yates executed a note (1994 note),

promising to pay Adena $1,241,409, plus 5 percent interest, due

December 31, 1995.   The 1994 note evidenced the amount Mr. Yates

owed Adena relating to the 1994 transfers to Fox Trot.    On

October 15, 1995, Mrs. Yates repaid $855,000 to Adena, and on

December 31, 1995, Mr. Yates executed a new note to Adena for

$435,214.28 (i.e., the balance owing on the 1994 note).

     Petitioners filed joint income tax returns for 1994, 1995,

and 1996.   On their 1994, 1995, and 1996 income tax returns

petitioners claimed losses passed through from Fox Trot.       In the

notices of deficiency, respondent determined that petitioners

lacked sufficient basis in Fox Trot to pass through its losses

during the years in issue, disallowing losses of $837,556,

$854,372, and $728,243 in 1994, 1995, and 1996, respectively, and

a net operating loss deduction of $522,439 in 1995.

                              OPINION

     Respondent contends that the transfers from Adena to Fox

Trot were intercompany loans that did not affect petitioners’

basis in Fox Trot.   Petitioners contend:   (1) The transfers from

Adena to Fox Trot before September 1, 1994, were, in substance,

transfers from Mr. Yates to Fox Trot that increased Mr. Yates’

stock basis in Fox Trot; and (2) the transfers after September 1,
                                - 6 -

1994, were gifts from Mr. Yates to Mrs. Yates that increased her

basis in Fox Trot.    We agree with petitioners.

     Pursuant to section 1366(a), an S corporation shareholder is

allocated a pro rata share of its income and losses, which may be

reported on such shareholder’s individual income tax return.

Pursuant to section 1366(d), a shareholder, however, may deduct S

corporation losses only to the extent of such shareholder’s

basis.   Basis in an S corporation is acquired by contributing

capital or lending money to the corporation.    See sec. 1366(d).

     Generally, a shareholder must make an actual economic outlay

to increase his basis in an S corporation.    See Pugh v.

Commissioner, 213 F.3d 1324, 1330 (11th Cir. 2000), affg. T.C.

Memo. 1999-38.

     Because of Mr. Yates’ frequent unavailability, Adena made

direct transfers from 1993 through October 15, 1995, to or for

Fox Trot.    During 1993 through October 1, 1994, Mr. Adams

typically made temporary postings, until he determined the

correct treatment of the transfers.

     Petitioners paid personal expenses from the Adena account

and used Adena as an incorporated pocketbook.      To the extent

transfers from Adena were contributions or loans to Fox Trot from

its shareholder (i.e., Mr. or Mrs. Yates) the shareholder’s basis

increased.    Mr. Yates transferred money he held in Adena’s

account to Fox Trot.    Further, for transfers from January 1
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through September 1, 1994, Fox Trot incurred indebtedness to Mr.

Yates of $853,557.   Accordingly, Mr. Yates was entitled to

increase his basis in Fox Trot by $2,774,706 as a result of the

loans and capital contributions made to Fox Trot before Mr. Yates

transferred the Fox Trot stock to Mrs. Yates.        Culnen v.

Commissioner, T.C. Memo. 2000-139 (allowing an S corporation

shareholder to increase his basis as a result of similar

transactions).

     The uncontradicted and credible testimony of Mr. Yates

established that Mr. Yates made gifts to Mrs. Yates of the

subsequent transfers from Adena.    Mr. Yates, however, skipped the

steps of having Adena transfer such funds to him, depositing the

funds into petitioners’ joint account, and then having Mrs. Yates

write a check to Fox Trot.   Accordingly, these transfers

increased Mrs. Yates’ basis in Fox Trot.

     Contentions we have not addressed are moot, irrelevant, or

meritless.

     To reflect the foregoing,


                                              Decisions will be entered

                                         under Rule 155.
