                          T.C. Memo. 2009-29



                       UNITED STATES TAX COURT



         DONALD L. AND EVELYN RUSSELL, ET AL.,1 Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent2



     Docket Nos. 4425-05, 4456-05,       Filed February 9, 2009.
                 4688-05.



     Jon J. Jensen, for petitioners.

     Jack Forsberg, for respondent.



                   SUPPLEMENTAL MEMORANDUM OPINION


     HAINES, Judge:    In Russell v. Commissioner, T.C. Memo. 2008-

246, the Court held that instruments entitled “notes”, “REMC


     1
      Cases of the following petitioners are consolidated
herewith: Loren R. and Dawn Kopseng, docket No. 4456-05; United
Energy Corp., docket No. 4688-05.
     2
      This opinion supplements our previous Memorandum Opinion in
Russell v. Commissioner, T.C. Memo. 2008-246, filed Oct. 30,
2008.
                              - 2 -

ledger debt”, and “short-term debt” did not constitute

“indebtedness of the S corporation to the shareholder” for

purposes of determining whether petitioners Donald Russell (Mr.

Russell) and Loren Kopseng (Mr. Kopseng) had sufficient basis

under section 1366(d)(1)(B) to claim their distributive shares of

the loss incurred by Missouri River Royalty Corp (MRRC).3

However, the Court did not determine whether United Energy Corp.

(UEC) realized gain on the Russell ledger debt and the Kopseng

ledger debt, conceded by the parties as being indebtedness of the

S corporation to the shareholders pursuant to the deemed

satisfaction rules of section 1.1502-13(g)(4), Income Tax Regs.,

when that debt was contributed to UEC.   This matter is now before

the Court on respondent’s motion for supplemental opinion.

                           Background

     Although the findings of fact are set forth in Russell v.

Commissioner, T.C. Memo. 2008-246, for completeness and

convenience we will repeat the background here, omitting only the

passages related to the financial instruments of the UEC group

other than the Russell ledger debt and the Kopseng ledger debt.

At the time the Russells and the Kopsengs filed their petitions,




     3
      Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended, and all Rule references
are to the Tax Court Rules of Practice and Procedure. Amounts
are rounded to the nearest dollar.
                                  - 3 -

they resided in North Dakota.     At the time UEC filed its

petition, its principal place of business was in North Dakota.

      On May 18, 2005, respondent sent petitioners notices of

deficiency for the years at issue.        Petitioners filed timely

petitions with this Court.

I.    Members of the UEC Group and Predecessor Entities

      A.    United Energy Corp.

      UEC was incorporated under the law of North Dakota on August

29, 1997.    At all times since its incorporation, UEC has used the

accrual method of accounting for tax and financial reporting

purposes and has had a fiscal year and taxable year ending June

30.   At all times from the initial issuance of stock by UEC on

September 1, 1997, through June 30, 1998, all of UEC’s

outstanding stock was owned by Mr. Russell and Mr. Kopseng.

      UEC timely filed a Form 1120, U.S. Corporation Income Tax

Return, for its initial short taxable year beginning September 1,

1997, and ending June 30, 1998.     UEC filed its Form 1120 as the

common parent of a consolidated group of corporations consisting

of itself, Rainbow Gas Co. (RGC), Rainbow Energy Marketing Corp.

(REMC), MRRC, and Energy Leasing Corp. (ELC).

      B.    Rainbow Gas Co.

      Before 1997 the assets of RGC were owned by a North Dakota

limited partnership (RGC Partnership).       As of August 29, 1997,

all of the general and limited partnership interests in RGC
                                 - 4 -

Partnership were owned by Mr. Russell and Mr. Kopseng.     On August

29, 1997, in a transaction qualifying as a tax-free exchange

under section 351(a), all the assets of RGC Partnership were

transferred to RGC, a newly formed North Dakota corporation, in

exchange for the issuance of 375 shares of RGC stock to Mr.

Russell and 625 shares of RGC stock to Mr. Kopseng.     The RGC

shares issued to Mr. Russell and Mr. Kopseng constituted all of

the outstanding shares of RGC.

     C.     Rainbow Energy Marketing Corp.

     REMC is a North Dakota corporation.     As of September 1,

1997, REMC had 4,512,205 shares outstanding, of which 1,108,056

were owned by Mr. Russell and 2,701,149 were owned by Mr.

Kopseng.

     D.    Missouri River Royalty Corp.

     MRRC is a North Dakota corporation which was incorporated on

September 7, 1984.    At all times before September 1, 1997, MRRC

was an S corporation.    Effective September 1, 1997, MRRC

voluntarily revoked its S corporation election.     MRRC filed a

Form 1120S, U.S. Income Tax Return for an S Corporation, for the

short taxable year beginning January 1, 1997, and ending August

31, 1997.    At all relevant times before September 1, 1997, MRRC

had 30,000 shares outstanding, of which Mr. Russell and Mr.

Kopseng each owned 15,000 shares.
                               - 5 -

II.   The Section 351 Transaction

      On September 1, 1997, Mr. Russell received 350 shares of UEC

stock and Mr. Kopseng received 650 shares of UEC stock as part of

a transaction qualifying as a tax-free exchange under section

351(a).   As part of the section 351 transaction, Mr. Russell made

a contribution to UEC of 375 shares of RGC stock, 1,108,056

shares of REMC stock, and 15,000 shares of MRRC stock.   Mr.

Kopseng made a contribution to UEC of 625 shares of RGC stock,

2,701,149 shares of REMC stock, and 15,000 shares of MRRC stock.

      UEC’s audited consolidated financial statement for the

period ending June 30, 1998, contained the following statement

respecting the section 351 transaction:

           In August, 1997 United Energy Corporation (the
      company) exchanged 1,000 shares of its common stock for
      100% of the shares of Rainbow Gas Company and Missouri
      River Royalty and 85% of the outstanding shares of
      Rainbow Energy Marketing Corporation. This transaction
      was accounted for under the requirements of
      interpretation 39 of Accounting Standards Board Opinion
      #16, whereby the acquisitions were treated as a
      transfer of shares between companies with common
      control in a manner similar to a pooling of interest.
      Accordingly, all assets and liabilities of the merged
      companies were recognized at historical cost and the
      historical financial statements of Rainbow Gas Company,
      Missouri River Royalty Corporation and Rainbow Energy
      Marketing Corporation became a component of the
      historical financial statements of the company.


The audited financial statement made no reference to any

assumption or contribution of liabilities being part of the

section 351 transaction.
                               - 6 -

     In their capacities as the incorporators and directors

of UEC, Mr. Russell and Mr. Kopseng executed a Consent to Action

Taken in Lieu of Organizational Meeting dated September 3, 1997

(consent).   With respect to the section 351 transaction, the

consent stated as follows:

          The directors were authorized to issue stock
     pursuant to the attached Resolution in the amount of
     650 shares to Loren R. Kopseng in return for his
     contribution of shares from Rainbow Gas Company,
     Missouri River Royalty Corporation, and Rainbow Energy
     Marketing Corporation, and has [sic] been authorized to
     issue 350 shares to Donald L. Russell in return for his
     contribution of shares from Rainbow Gas Company,
     Missouri River Royalty Corporation, and Rainbow Energy
     Marketing Corporation.

The consent made no reference to any assumption or contribution

of liabilities being part of the section 351 transaction.

     In their capacities as the directors and officers of UEC,

Mr. Russell and Mr. Kopseng executed a resolution dated September

3, 1997.   The resolution stated:

          Loren R. Kopseng has transferred 625 shares of
     Rainbow Gas Company stock, 2,701,149 shares of Rainbow
     Energy Marketing Corporation stock, and all shares of
     Missouri River Royalty Corporation stock to United
     Energy Corporation. In return for the transfer of
     these shares, United Energy Corporation is hereby
     authorized to issue 650 shares of United Energy
     Corporation’s stock to Loren R. Kopseng.
          Donald L. Russell has transferred 375 shares of
     Rainbow Gas Company stock, 1,108,056 shares of Rainbow
     Energy Marketing Corporation stock, and all shares of
     Missouri River Royalty Corporation stock to United
     Energy Corporation. In return for the transfer of
     these shares, United Energy Corporation is hereby
     authorized to issue 350 shares of United Energy
     Corporation’s stock to Donald L. Russell.
                               - 7 -

     The resolution made no reference to any assumption or

contribution of liabilities being part of the section 351

transaction.

III. The Russell and the Kopseng Ledger Debts

     MRRC required capital to purchase and rework oil wells.

MRRC acquired capital through a variety of transactions discussed

in Russell v. Commissioner, T.C. Memo. 2008-246.   The only

instruments relevant to the current proceedings are the Russell

ledger debt and the Kopseng ledger debt.

     Before April 5, 1996, Mr. Russell made a series of cash

advances to MRRC which MRRC used for working capital (the Russell

ledger debt).   As of April 5, 1996, the principal balance of

these advances totaled $562,705.   In MRRC’s books the Russell

ledger debt was recorded as a liability in a ledger account

entitled “Notes Payable Russell” (the notes payable Russell

account).

     On April 5, 1996, MRRC issued a $562,705 note to Mr. Russell

for the Russell ledger debt (the Russell ledger debt note).     As

of September 1, 1997, the principal balance of the Russell ledger

debt was $65,527.

     Before April 5, 1996, Mr. Kopseng made a series of cash

advances to MRRC which MRRC used for working capital (the Kopseng

ledger debt).   As of April 5, 1996, the principal balance of

these advances totaled $611,144.   In MRRC’s books the Kopseng
                                 - 8 -

ledger debt was recorded as a liability in a ledger account

entitled “Notes Payable Kopseng” (the notes payable Kopseng

account).

     On April 5, 1996, MRRC issued a $611,144 note to Mr. Kopseng

for the Kopseng ledger debt (the Kopseng ledger debt note).   As

of September 1, 1997, the principal balance of the Kopseng ledger

debt was $117,438.

     The Russell ledger debt and the Kopseng ledger debt were

demand obligations.   Interest on the Russell ledger debt and the

Kopseng ledger debt was calculated using monthly compounding.

There was no requirement that interest accruing on the Russell

ledger debt and the Kopseng ledger debt be paid at least

annually.

     As of September 1, 1997, the fair market value of the

Russell ledger debt was equal to the Russell ledger debt’s

principal balance of $65,527.    Likewise, the fair market value of

the Kopseng ledger debt was equal to the Kopseng ledger debt’s

principal balance of $117,438.

     Respondent concedes that the Russell ledger debt and the

Kopseng ledger debt constituted indebtedness of MRRC to Mr.

Russell and Mr. Kopseng for purposes of section 1366(d)(1)(B).
                                - 9 -

IV.   Mr. Russell’s and Mr. Kopseng’s Bases in Indebtedness and
      MRRC Stock

      As of the beginning of MRRC’s short taxable year ending

August 31, 1997, Mr. Russell’s basis in his MRRC stock was

$150,151, and Mr. Kopseng’s basis in his MRRC stock was zero.

      The MRRC 1997 Form 1120S reported an ordinary loss of

$1,117,540, interest income of $250, and dividend income of $208.

Consistent with the MRRC 1997 Form 1120S, the following items

from MRRC’s taxable year ended August 31, 1997, were reported on

Mr. Russell’s 1997 return and on Mr. Kopseng’s 1997 return.

                       Item                 Amount

                  Ordinary loss            $558,770
                  Interest income               125
                  Dividend income               104

      As of the end of MRRC’s taxable year ended August 31, 1997:

(1) Mr. Russell’s basis in the Russell ledger debt was $65,527

less the amount by which his basis in the Russell ledger debt was

properly reduced under section 1367(b)(2) on account of items of

MRRC for its taxable year ending August 31, 1997, and (2) Mr.

Kopseng’s basis in the Kopseng ledger debt was $117,438 less the

amount by which his basis in the Kopseng ledger debt was properly

reduced under section 1367(b)(2) on account of items of MRRC for

its taxable year ending August 31, 1997.

                              Discussion

      At issue is whether the Russell ledger debt and the Kopseng

ledger debt were contributed to UEC as part of the section 351
                              - 10 -

transaction and whether section 1.1502-13(g)(3) or (4), Income

Tax Regs., applies to govern the transaction.     Petitioners argue

that UEC realized no gain from the Russell ledger debt and the

Kopseng ledger debt by virtue of section 1.1502-13(g)(5), Example

(2), Proposed Income Tax Regs., 63 Fed. Reg. 70356 (Dec. 21,

1998).   Respondent argues that the transaction is instead

governed by section 1.1502-13(g)(4), Income Tax Regs., which

would cause UEC to recognize gain upon the contribution of the

Russell ledger debt and the Kopseng ledger debt to the extent

that the value of each debt exceeds its basis.     See sec. 1.1502-

13(g)(5), Example (4), Income Tax Regs.     We agree with

respondent.   We need not decide whether the burden of proof

shifts to respondent under section 7491(a) because we decide this

case on the basis of the preponderance of the evidence.

     Mr. Russell and Mr. Kopseng were entitled to deduct

additional loss from MRRC after the section 351 transaction

because MRRC’s Russell ledger debt and Kopseng ledger debt each

constituted an “indebtedness of the S corporation to the

shareholder”.   Sec. 1366(d)(1)(B).    However, their respective

bases in the Russell ledger debt and the Kopseng ledger debt were

each reduced by an amount equal to the additional loss allowed.

Sec. 1367(b)(2)(A).   As a result, UEC’s bases in the indebtedness

transferred to it by Mr. Russell and Mr. Kopseng under section

362(a) were less than the indebtedness’ principal balance,
                                - 11 -

creating the potential for the recognition of built-in gain.4

The outcome depends on which provision of the consolidated return

regulations governs the transaction.

     The consolidated return regulations provide special rules

that apply to intercompany obligations.   For purposes of these

rules, an “intercompany obligation” is defined as “an obligation

between members, but only for the period during which both

parties are members.”   Sec. 1.1502-13(g)(2)(ii), Income Tax Regs.

     In cases where a nonintercompany obligation becomes an

intercompany obligation, such as through a section 351

transaction, there is a deemed satisfaction and reissuance of the

obligation immediately after the transaction.    Sec. 1.1502-

13(g)(4), Income Tax Regs.   If the obligation is debt, the debt

is treated as satisfied and a new debt issued to the holder with

a new holding period in an amount determined under the principles

of section 1.108-2(f), Income Tax Regs.    Sec. 1.1502-13(g)(5),

Example (4), Income Tax Regs.    Where, as here, the debt was not

acquired by purchase less than 6 months before the acquisition

date, the deemed satisfaction will result in the realization of

income by the holder to the extent that the fair market value of

the indebtedness on the acquisition date is greater than the




     4
      See the discussion of sec. 1.108-2(f)(2), Income Tax Regs.,
infra.
                               - 12 -

transferred basis of the indebtedness.   Sec. 1.108-2(f)(2),

Income Tax Regs.

     By contrast, in certain cases where an intercompany

obligation remains an intercompany obligation or becomes a

nonintercompany obligation through a transaction, the obligation,

if it is debt, is treated as satisfied immediately before the

transaction.   Sec. 1.1502-13(g)(3), Income Tax Regs.

     The MRRC debts became intercompany obligations when they

were transferred to UEC along with MRRC stock in the section 351

transaction on September 1, 1997.   See sec. 1.1502-13(g)(2)(ii),

Income Tax Regs.   Before this transaction, the MRRC debts were

obligations between a nonmember (MRRC) and other nonmembers (Mr.

Russell and Mr. Kopseng).   Thus, the transaction is governed by

section 1.1502-13(g)(4), Income Tax Regs.   Accordingly, the

Russell ledger debt and the Kopseng ledger debt were contributed

by MRRC to UEC on September 1, 1997, and UEC realized gain on its

deemed satisfaction after the debts became an intercompany

obligation.    UEC realized an amount on the deemed satisfaction of

the debt equal to the debts’ fair market value over its

transferred basis.   Sec. 1.1502-13(g)(4)(ii)(B), Income Tax Regs.

     In reaching our holdings herein, we have considered all

arguments made, and, to the extent not mentioned above, we

conclude they are moot, irrelevant, or without merit.
                        - 13 -

To reflect the foregoing,


                                  Decisions will be entered

                             under Rule 155.
