                             T.C. Memo. 2017-174



                        UNITED STATES TAX COURT



                  WILLIAM J. RUTTER, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 15480-14.                        Filed September 7, 2017.



      Robert S. Horwitz and Edward M. Robbins, Jr., for petitioner.

      Adam B. Landy, Thomas R. Mackinson, and Kaelyn J. Romey, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


      LAUBER, Judge: With respect to petitioner’s Federal income tax for 2009,

the Internal Revenue Service (IRS or respondent) determined a deficiency of
                                            -2-

[*2] $978,778 and an accuracy-related penalty of $195,756 under section 6662(a).1

The principal issue for decision is whether petitioner is entitled to a business bad

debt deduction under section 166(a). We hold that he is not and that he is liable

for the accuracy-related penalty that respondent has determined.

                               FINDINGS OF FACT

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

fact and the attached exhibits are incorporated by this reference. Petitioner resided

in California when he filed his petition.

      Petitioner is a world-renowned scientist in the field of biotechnology. He

received a bachelor of science degree from Harvard College, a master of science

degree from the University of Utah, and a Ph.D. in biochemistry from the Univer-

sity of Illinois. He completed postdoctoral work at several universities, including

the University of Wisconsin and the Nobel Institute in Sweden.

      In 1955 petitioner began his academic career as a professor of biochemistry

at the University of Illinois. He moved to the University of Washington in 1965

and was subsequently recruited by the University of California, San Francisco

(UCSF). He served there from 1969 to 1982 as the Herzstein professor and chair

      1
        All statutory references are to the Internal Revenue Code (Code) in effect
for the relevant year, and all Rule references are to the Tax Court Rules of Practice
and Procedure. We round all monetary amounts to the nearest dollar.
                                       -3-

[*3] of the biochemistry and biophysics department. He has published 400

scientific papers during his career and holds more than 25 patents. He has re-

ceived numerous awards and accolades for his accomplishments in the biotech-

nology field. A building on a UCSF campus bears his name.

      Shortly before leaving UCSF petitioner formed Chiron Corp. (Chiron), one

of the first publicly held biotechnology companies. Under his leadership Chiron

made major contributions in the areas of vaccines and infectious diseases. These

included: (1) sequencing the HIV genome; (2) discovering the Hepatitis C virus;

(3) developing a diagnostic test to detect HIV and the Hepatitis B and C viruses;

(4) developing the first vaccine for the Hepatitis B virus using recombinant DNA

technology; and (5) codeveloping a method to clone human insulin genes to pro-

duce vaccines that are used throughout the world today.

      In 1995 Ciba-Geigy, a Swiss pharmaceutical company, acquired 49% of

Chiron’s outstanding stock. Ciba-Geigy had previously partnered with Chiron to

produce vaccines using mass-production techniques. Ciba-Geigy subsequently

merged with another company to form Novartis. Novartis purchased from peti-

tioner the remaining 51% of Chiron’s stock in 2006.

      Following Ciba-Geigy’s initial investment in Chiron, petitioner made other

startup investments in the biotechnology field. In 1999 he formed Synergenics, a
                                        -4-

[*4] service company that performed back-office support for the startup

companies in which he invested. During 2009 Synergenics was a disregarded

entity whose income and expenses petitioner reported on a Schedule C, Profit or

Loss From Business.

A.    The Business

      Although petitioner created numerous startup companies, the focus of our

interest is iMetrikus (originally called Healthvantage, Inc.), which petitioner ac-

quired in 1999. In June 2002 he incorporated iMetrikus International (IM), and

iMetrikus became its wholly owned subsidiary. For convenience, we will refer to

these companies collectively as IM.

      IM was a “telehealth” company that developed technology systems to en-

able remote monitoring of patients’ health. The products it developed included

MediCompass and Metrilink. MediCompass was an application designed to

access clinical data to help doctors improve patient compliance and optimize

treatment plans. MetriLink was a device designed to upload data from end-user

monitoring tools to a “personal health record” to help patients have better control

over their health regimens.

      IM had an unusual capital structure. Although petitioner was its driving

force, he owned no common stock. IM had about 70 common shareholders, in-
                                        -5-

[*5] cluding key employees and some of petitioner’s family members. But

common stock formed a minuscule portion of its capital structure. From the time

petitioner incorporated IM through December 2009, IM’s primary funding source

took the form of cash advances from petitioner.2

      Between September 2000 and February 2002 petitioner made 39 separate

cash advances to IM totaling approximately $10.6 million. For each advance IM

executed a substantially identical convertible promissory note. Each note pro-

vided that IM had the right to convert the note into common or preferred stock

depending on certain events. Each of the 39 notes bore 7% interest. IM duly paid

all interest on these notes when due.

      Between February 2002 and May 2005 petitioner advanced to IM another

$22 million. Only $3.4 million of these advances was covered by promissory

notes. For the remaining $18.6 million petitioner received no promissory note or

other evidence of indebtedness. IM recorded all these advances as loans on its

books, and these advances continued to accrue interest at 7%, the rate appearing

on the last promissory note that petitioner and IM had executed. But after Feb-

ruary 2002 IM paid no interest on any of this purported indebtedness.


      2
      Petitioner made many of these advances through a revocable trust. For
convenience, we will refer to all advances as having been made by petitioner.
                                       -6-

[*6] By May 2005 petitioner had advanced approximately $43.4 million to IM.

That same month IM converted the entirety of this purported indebtedness to pre-

ferred stock as part of a “Series D Preferred Stock Financing.” The May 2005

conversion gave petitioner preferred stock with a face value of $43.4 million. Af-

ter this conversion roughly 78% of IM’s capital structure consisted of preferred

stock owned by petitioner.

       Between May 2005 and December 2009 petitioner made additional cash ad-

vances to IM totaling $43.04 million. These advances were IM’s sole source of

funding during this period. Petitioner generally made these advances monthly or

semimonthly in amounts sufficient to cover IM’s budgeted operating expenses for

the ensuing period.

       IM executed no promissory notes for these advances and furnished no col-

lateral. As before, it recorded these advances on its books as loans and accrued in-

terest at the 7% rate reflected on the promissory notes executed in 2002. But it

never paid a penny of interest on any of this purported indebtedness. As of De-

cember 31, 2009, the balance of petitioner’s open-account advances to IM, includ-

ing accrued interest, was approximately $47.5 million. That sum, coupled with his

$43.4 million of preferred stock, constituted roughly 92% of IM’s capital structure

as of that date.
                                       -7-

[*7] IM’s business plan was to create pilot programs for telehealth products and

services by seeking partnerships with pharmaceutical companies, healthcare pro-

viders, and technology companies. Its partners before 2009 included Yahoo, Web-

MD, and Aetna. Although none of these ventures yielded profits, IM appeared to

have better somewhat prospects in 2009. Early that year petitioner and IM officers

held separate discussions with executives from General Electric (GE) and Google

concerning a possible equity investment in IM. The discussions with GE fizzled

out early because GE acquired another business to develop this field.

      IM’s discussions with Google appeared more promising. Between July and

October 2009 petitioner and Google personnel exchanged emails concerning a

possible strategic partnership. Google was interested in integrating IM’s devices

into Google applications on cell phones, tablets, and personal computers.

      Petitioner prepared a Powerpoint presentation highlighting the hoped-for

benefits of pairing IM’s advanced technology with Google’s market share in the

technology field. At the end of October, Cathy Gordon, a director of business

development at Google, offered to connect petitioner with Google executives for

further discussion of a partnership arrangement. In early December 2009 petition-

er prepared another Powerpoint presentation emphasizing the large market
                                       -8-

[*8] available for IM’s devices (including patients with significant medical needs

and thousands of medical professionals, insurance companies, and pharmacies).

      The ensuing email correspondence suggests that Google was genuinely in-

terested in integrating IM’s products into its applications. In December 2009 pe-

titioner emailed IM’s employees to inform them that “convergent forces” had “cre-

ated great potential for change” and had “created an unusual opportunity for con-

sumer oriented approaches.” This upbeat assessment contrasted with his dour as-

sessment at year-end 2008 when he informed IM’s employees that the company

was going through “a period of extreme financial and economic stress.”

      Discussions between IM and Google continued through January and Febru-

ary 2010. But in March 2010 the dialogue turned south. In an internal email dated

March 22, 2010, Google executives stated that they “don’t see * * * [a partnership

with IM] being a cash infusion” because of concerns over IM’s marketplace posi-

tion and lack of success. After further internal discussions Google finally decided

in June 2010 not to enter into a partnership with IM.

      IM incurred substantial losses in most years of its existence. Its aggregate

losses from 1999 through 2008 exceeded $75 million. For 2007 it had revenue of

$1,480,138 and operating expenses of $10,612,411; for 2008 it had revenue of

$383,090 and operating expenses of $9,750,156; and for 2009 it had revenue of
                                        -9-

[*9] $482,036 and operating expenses of $8,174,559. It incurred additional net

operating losses (NOLs) of about $8 million during 2010 and carried over

approximately $83 million in NOLs to 2011. All of this stood in stark contrast to

IM’s projections at year-end 2007 that its revenues would increase to $15 million

in 2008, to $50 million in 2009, and to $197 million by 2012.

B.    The Writedown

      Because of IM’s inability to form successful partnerships, petitioner began

questioning the collectibility of his advances. Sometime in late 2009 he asked

Laurence Bardoff, Synergenics’ senior vice president, to evaluate IM’s financial

condition. Mr. Bardoff informed petitioner that its condition was precarious: Its

2008 revenue was 98% below target, and it had massive NOLs. Without petition-

er’s continued cash infusions the company would have to fold.

      Between September and December 2009 petitioner discussed with Mr.

Bardoff and with his personal accountant the possibility of claiming a bad debt

loss deduction for some or all of his advances. In a series of emails Mr. Bardoff

took the position that all of petitioner’s advances were debt and that the advances

should be written off individually under a “first-in, first-out” approach. Mr. Bard-

off initially used $10 million as a placeholder number for the debt writedown. At

the end of December the writedown was lowered to $8.55 million.
                                        - 10 -

[*10] While Mr. Bardoff was preparing documents to implement the $8.55

million writedown, petitioner’s personal attorney prepared a promissory note to

consolidate the $34.5 million of advances that petitioner did not plan to write off.

While these documents were being prepared, petitioner made additional monthly

advances totaling $600,000 to IM. In March 2010 petitioner and IM executed a

debt restructuring agreement, a consolidated promissory note for $34.5 million,

and a certificate of debt forgiveness of $8.55 million. All of these documents were

backdated to December 31, 2009.

      IM continued to operate at least through 2013. Petitioner revised its busi-

ness model to focus on product lines in social networking. He advanced another

$37.75 million to IM during 2010-2013, again evidenced by no promissory notes.

C.    The Examination

      Petitioner timely filed his 2009 Federal income tax return. He included in

this return a Schedule C for Synergenics that reported (among other things) an

$8.55 million business bad debt loss reflecting the writedown of his advances to

IM. According to petitioner, this loss corresponded to advances he had made dur-

ing 2005 and 2006 after the conversion of his previous advances to preferred

stock. No accrued interest was included in the $8.55 million writedown. Peti-

tioner claimed this loss in full as a deduction against ordinary income.
                                        - 11 -

[*11] The IRS selected petitioner’s 2009 return for examination. It disallowed the

business bad debt deduction in full, made various computational adjustments, and

determined an accuracy-related penalty. It issued petitioner a timely notice of de-

ficiency, and he timely petitioned this Court.

D.    The Experts

      At trial petitioner presented the report and testimony of Brian MacKenzie, a

valuation expert and principal with KPMG. The Court recognized Mr. MacKenzie

as an expert in business valuation. He has prepared more than 500 appraisals in

his career.

      Mr. MacKenzie performed an appraisal that estimated IM’s fair market

value (FMV) at year-end 2008 and 2009. For both years he used the market ap-

proach and the income approach. In determining IM’s value at year-end 2008 he

relied heavily on management’s projections of future revenue, cashflows, and ex-

penses as stated in a financial forecast dated December 31, 2007. Notwithstanding

the worldwide financial crisis, he opined that market conditions had not materially

changed during 2008. He used the weighted average of his outcomes under the

two approaches to determine that IM’s FMV at year-end 2008 was $55.4 million.

      In determining IM’s value at year-end 2009 Mr. MacKenzie used the same

valuation approaches but adjusted his appraisal downward, chiefly because of
                                       - 12 -

[*12] management’s representations that increased competition had substantially

diminished its prospects. Mr. MacKenzie relied heavily on management’s

representation that discussions with Google had effectively collapsed by year-end

2009. On the basis of this information he determined that the company’s FMV

during 2009 had declined by 74%, from $55.4 million to $14.3 million.

      Respondent offered, and the Court recognized, James E. McCann as an ex-

pert in business valuation. Mr. McCann opined that Mr. MacKenzie’s appraisal

was flawed in several respects. With respect to the year-end 2008 valuation, he

opined that Mr. MacKenzie gave undue weight to management’s year-end 2007

financial forecast. He noted that the macroeconomic environment had deteriorated

during the ensuing 12 months. And he noted that management’s revenue projec-

tions were wildly inflated: IM’s actual revenues for 2008 were $383,090, about

98% below the $15 million projected at year-end 2007.

      Mr. McCann opined that IM’s financial condition at year-end 2009 did not

differ materially from its financial condition at year-end 2008. At both dates IM’s

cash balances were insufficient to cover its expenses for more than two months. It

was thus entirely dependent at all times on cash infusions from petitioner to stay

afloat. He accordingly discerned no factual basis for Mr. MacKenzie’s hypothesis

that IM’s FMV had declined by 74% during calendar year 2009.
                                       - 13 -

[*13]                                OPINION

        The IRS’ determinations in a notice of deficiency are generally presumed

correct, and the taxpayer bears the burden of proving them erroneous. Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The taxpayer bears the

burden of proving his entitlement to deductions allowed by the Code and of sub-

stantiating the amounts of expenses underlying claimed deductions. INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a), Income Tax Regs.

Petitioner contends that respondent bears the burden of proof because he raised

“new matter[s]” at trial and in his post-trial briefs. See Rule 142(a)(1). Because

we decide all factual issues on a preponderance of the evidence, we need not de-

cide who has the burden of proof. See sec. 7491(a); Estate of Turner v. Commis-

sioner, 138 T.C. 306, 309 (2012), supplementing T.C. Memo. 2011-209.

I.      Bad Debt Loss

        A.    Governing Statutory Framework

        Section 166(a)(1) allows as a deduction any bona fide debt that becomes

worthless within the taxable year. For a nonbusiness bad debt held by a taxpayer

other than a corporation, section 166(a)(1) does not apply, and the taxpayer is

allowed a short-term capital loss for the taxable year in which the debt becomes

completely worthless. Sec. 166(d)(1); sec. 1.166-5(a)(2), Income Tax Regs.
                                       - 14 -

[*14] Section 166(d)(2) defines a business debt as “a debt created or acquired

* * * in connection with a trade or business of the taxpayer” or “a debt the loss

from the worthlessness of which is incurred in the taxpayer’s trade or business.”

To be eligible to deduct a loss as a business bad debt, an individual taxpayer must

show that he was engaged in a trade or business and that the debt was proximately

related to that trade or business. Putoma Corp. v. Commissioner, 66 T.C. 652, 673

(1976), aff’d, 601 F.2d 734 (5th Cir. 1979); sec. 1.166-5(b), Income Tax Regs.

      A bona fide debt is a debt that arises from “a debtor-creditor relationship

based upon a valid and enforceable obligation to pay a fixed or determinable sum

of money.” Kean v. Commissioner, 91 T.C. 575, 594 (1988); sec. 1.166-1(c),

Income Tax Regs. A gift or contribution to capital is not considered a “debt” for

purposes of section 166. Kean, 91 T.C. at 594. Whether a purported loan is a

bona fide debt for tax purposes is determined from the facts and circumstances of

each case. See A.R. Lantz Co. v. United States, 424 F.2d 1330, 1333 (9th Cir.

1970); Gross v. Commissioner, 401 F.2d 600, 603 (9th Cir. 1968), aff’g T.C.

Memo. 1967-31; Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493 (1980).

      Advances made by an investor to a closely held or controlled corporation

may properly be characterized, not as a bona fide loan, but as a capital contribu-

tion. See Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968);
                                         - 15 -

[*15] Shaw v. Commissioner, T.C. Memo. 2013-170, 106 T.C.M. (CCH) 54, 56,

aff’d, 623 F. App’x 467 (9th Cir. 2015). In general, advances made to an

insolvent debtor are not debts for tax purposes but are characterized as capital

contributions or gifts. See Dixie Dairies Corp., 74 T.C. at 497; Davis v.

Commissioner, 69 T.C. 814, 835-836 (1978). For an advance to constitute a bona

fide loan, the purported creditor must expect that the amount will be repaid. See

CMA Consol., Inc. v. Commissioner, T.C. Memo. 2005-16, 89 T.C.M. (CCH) 701,

724.

       To give rise to a deduction under section 166(a)(1), a debt must have be-

come wholly worthless during the tax year. Sec. 1.166-3(b), Income Tax Regs.;

see Bodzy v. Commissioner, 321 F.2d 331, 335 (5th Cir. 1963), aff’g in part, rev’g

in part T.C. Memo. 1962-40. In the case of a partially worthless debt, section

166(a)(2) provides that, “[w]hen satisfied that a debt is recoverable only in part,

the Secretary may allow such debt, in an amount not in excess of the part charged

off within the taxable year, as a deduction.” “Before a taxpayer may deduct a debt

in part, he must be able to demonstrate to the satisfaction of the district director

the amount thereof which is worthless and the part thereof which has been charged

off.” Sec. 1.166-3(a)(2)(iii), Income Tax Regs.
                                        - 16 -

[*16] This case presents three major questions under the statutory and regulatory

regime outlined above. These questions are: (1) whether petitioner’s advances to

IM constituted debt or equity; (2) if the advances constituted debt, and if the debt

was held by “a taxpayer other than a corporation,” whether the debt was a business

or a “nonbusiness” debt under section 166(d); and (3) if the debt was a business

debt, whether the writedown should be characterized as involving a “wholly

worthless” or “partially worthless” debt and whether petitioner satisfied the rele-

vant requirements for claiming a deduction. We address these questions in turn.

      B.     Debt vs. Equity

      Petitioner asserts that all of his advances to IM constituted bona fide debt

whereas respondent contends that petitioner made capital investments in his ca-

pacity as an investor. In determining whether an advance of funds constitutes

bona fide debt, “economic reality provides the touchstone.” Shaw, 106 T.C.M.

(CCH) at 56. If an outside lender would not have lent funds to the corporation on

the same terms as did the insider, an inference arises that the advance is a not a

bona fide loan. See Fin Hay Realty Co., 398 F.2d at 697. The Court may properly

characterize a transfer of funds to a corporation as other than a debt even if “all

the formal indicia of an obligation were meticulously made to appear.” Ibid.;

Davis, 69 T.C. at 835 (“The question of whether the advances * * * are debt or
                                       - 17 -

[*17] equity depends on the economic substance of the transactions between them

and not upon the form of the advances.”); see Estate of Reynolds v.

Commissioner, 55 T.C. 172, 201-202 (1970).

      Whether an advance of funds is treated as debt or equity “must be consid-

ered in the context of the overall transaction.” Hardman v. United States, 827 F.2d

1409, 1411 (9th Cir. 1987). Generally, the focus of the debt-vs.-equity inquiry is

whether the taxpayer intended to create a debt with a reasonable expectation of

repayment and (if so) whether that intent comports with creating a debtor-creditor

relationship. Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973).

The key to this determination is generally the taxpayer’s actual intent. Bauer v.

Commissioner, 748 F.2d 1365, 1367-1368 (9th Cir. 1984), rev’g T.C. Memo.

1983-120; A.R. Lantz Co., 424 F.2d at 1333.

      Absent stipulation to the contrary, appeal of this case would lie to the U.S.

Court of Appeals for the Ninth Circuit. That court has identified 11 nonexclusive

factors to determine whether an advance of funds gives rise to bona fide debt as

opposed to an equity investment. See Hardman, 827 F.2d at 1411-1412 (citing

Bauer, 748 F.2d at 1368); Bell v. Commissioner, __ F. App’x __, 2017 WL

2963547 (9th Cir. July 12, 2017) (reaffirming 11-factor test), aff’g T.C. Memo.

2015-111. Those factors are: (1) the labels on the documents evidencing the al-
                                         - 18 -

[*18] leged indebtedness; (2) the presence or absence of a maturity date; (3) the

source of payment; (4) the right of the alleged lender to enforce payment; (5)

whether the alleged lender participates in management of the alleged borrower; (6)

whether the alleged lender’s status is equal to or inferior to that of regular

corporate creditors; (7) the intent of the parties; (8) the adequacy of the alleged

borrower’s capitalization; (9) if the advances are made by shareholders, whether

the advances are made ratably to their shareholdings; (10) whether interest is paid

out of “dividend money”; and (11) the alleged borrower’s ability to obtain loans

from outside lenders. Hardman, 827 F.2d at 1411-1412.

             1.     Labels on the Documents

      In considering this factor we focus on the type of instrument evidencing the

advance. Id. at 1412. If the corporation issues a debt instrument, such as a bond, a

debenture, or a promissory note, that labeling supports the debt characterization.

Estate of Mixon v. Commissioner, 464 F.2d 394, 403 (5th Cir. 1972).

      IM issued promissory notes for the cash advances petitioner made before

March 2002. But those notes were converted to preferred stock in May 2005 and

are not involved here. The $43.04 million involved here was advanced between

May 2005 and December 2009. IM did not issue petitioner a single promissory
                                        - 19 -

[*19] note to cover any of those advances. Rather, petitioner advanced cash on

open account, generally monthly or semimonthly.3

      In connection with the writedown, IM issued petitioner in March 2010 a

promissory note for $34.5 million to consolidate the portion of his advances that

he chose not to write off. This document was backdated to December 31, 2009.

We find this document to have no probative value in the debt-vs.-equity analysis.

It did not cover the $8.55 million of advances for which petitioner claims a loss; it

was not created during the 2009 taxable year; and it was a self-serving document

created in connection with petitioner’s year-end tax planning. The absence of a

promissory note or other evidence of indebtedness for the $8.55 million of advan-

ces supports characterizing them as equity.

             2.    Fixed Maturity Date

      A fixed maturity date is indicative of an obligation to repay, which supports

characterizing an advance of funds as debt. Hardman, 827 F.2d at 1413; Estate of

Mixon, 464 F.2d at 404. Conversely, the absence of a fixed maturity date indi-

cates that repayment depends on the borrower’s success, which in turn supports

      3
        The labels appearing on documents may have less importance when the
parties are related. See Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 286
(1990). We do not find this proviso applicable here. IM issued discrete promis-
sory notes for each of petitioner’s advances before March 2002. He provided no
convincing explanation as to why it stopped doing so.
                                        - 20 -

[*20] characterization as equity. Hardman, 827 F.2d at 1413; Anchor Nat’l Life

Ins. Co. v. Commissioner, 93 T.C. 382, 405 (1989); see Monon R.R. v.

Commissioner, 55 T.C. 345, 359 (1970) (“[A] definite maturity date on which the

principal falls due for payment, without reservation or condition, * * * is a

fundamental characteristic of a debt.”).

      Because IM issued no promissory notes for any of the advances at issue,

there was of necessity no fixed maturity date. Petitioner testified that because he

was the only person advancing money to IM, he considered fixing of maturity

dates to be “futile, senseless, and counter to the interests of all involved.” We do

not see how this testimony helps petitioner’s position; it suggests that he was es-

sentially indifferent as to how the advances were characterized. We find that the

absence of any fixed maturity dates supports characterizing the advances as equity.

             3.    Source of Payments

      In considering this factor we examine the alleged borrower’s source of

funds to repay the advances. Hardman, 827 F.2d at 1413. Where repayments

depend on future corporate success, an equity investment may be indicated. Estate

of Mixon, 464 F.2d at 405; Calumet Indus., Inc. v. Commissioner, 95 T.C. 257,

287-288 (1990). And where prospects for repayment are questionable because of
                                        - 21 -

[*21] persistent corporate losses, an equity investment may be strongly indicated.

Calumet Indus., Inc., 95 T.C. at 288.

      IM had aggregate losses of $82.7 million during 1999-2009, and its ex-

penses vastly exceeded its revenue for all relevant years. As of December 31,

2009, it had made no payments of principal or interest on petitioner’s $43.04 mil-

lion of cash advances. For much of the period after May 2005, IM was kept afloat

because petitioner continued to provide monthly or semimonthly cash infusions

keyed to IM’s expected cash needs for the ensuing period. Thus, the most likely

source of repayment of petitioner’s advances would be further cash infusions from

petitioner himself. This does not support characterizing his advances as debt.

      Petitioner testified that he hoped to secure ultimate repayment upon sale of

IM to a third party or a third-party investment in IM. But this is the hope enter-

tained by the most speculative types of equity investors, such as venture capitalists

and private equity firms. Petitioner was a “classic capital investor hoping to make

a profit, not * * * a creditor expecting to be repaid regardless of the company’s

success or failure.” Calumet Indus., Inc., 95 T.C. at 287-288. The fact that a cor-

porate buyout was petitioner’s ultimate expected source of repayment strongly

supports characterization of his advances as equity.
                                         - 22 -

[*22]         4.     Right To Enforce Payment of Principal and Interest

        A definite obligation to repay, backed by the lender’s rights to enforce

payment, supports a debt characterization. Hardman, 827 F.2d at 1413. A lack of

security for repayment may support equity characterization. See Kraft Foods Co.

v. Commissioner, 232 F.2d 118, 122 (2d Cir. 1956) (suggesting that an “uncondi-

tional obligation” to pay principal and interest is a “necessary feature[] of indebt-

edness”); Litton Bus. Sys., Inc., 61 T.C. at 381; Am. Underwriters, Inc. v. Com-

missioner, T.C. Memo. 1996-548, 72 T.C.M. (CCH) 1511.

        Although petitioner’s advances were shown as loans on IM’s books, there

was no written evidence of indebtedness fixing IM’s obligation to repay at any

particular time. None of petitioner’s advances was secured by any collateral. And

even if petitioner under these circumstances were thought to have a “right to en-

force repayment,” that right was nugatory because his continued cash infusions

were the only thing keeping IM afloat. Had he enforced repayment, he would

simply have had to make a larger capital infusion the following month. This

strongly supports characterization of his advances as equity.

              5.     Participation in Management

        In considering this factor we examine whether the taxpayer making the ad-

vances receives increased management rights in the business. Increased manage-
                                         - 23 -

[*23] ment rights, in the form of greater voting rights or a larger share of the

company’s equity, support equity characterization. Hardman, 827 F.2d at 1413.

      Evaluation of this factor is tricky because IM had an unusual capital struc-

ture. Although petitioner had de facto control, he literally owned no common

stock. But through his cash advances and preferred stock he held about 92% of

IM’s capital. Petitioner contends that none of his advances gave him increased

voting rights or a larger equity share, and this is literally true. But it also means

little because he already had complete control of the company by virtue of his sta-

tus as its sole funder. To the extent this factor is relevant here it supports charac-

terizing the advances as equity.4

             6.     Status Relative to Regular Creditors

      In considering this factor we examine whether the alleged lender’s rights are

equal or inferior to those of an ordinary corporate creditor. Ibid. If the purported

creditor subordinates his right to repayment to that of other creditors, this supports

      4
        Petitioner contends that he intentionally used cash advances instead of
equity investments to fund IM because he “did not want to dilute the common
shareholders.” Our task in this case is to determine the true character of petition-
er’s advances for purposes of Federal tax law; how those advances would be
treated under California corporate law is an entirely separate question that is not
before us. If petitioner’s advances were treated as preferred stock under State
corporate law, they would not “dilute the common shareholders” any more than
petitioner did in May 2005 when he converted his prior $43.4 million of advances
to preferred stock.
                                         - 24 -

[*24] an equity characterization. See CMA Consol., Inc., T.C. Memo. 2005-16.

But see Kraft Foods Co., 232 F.2d at 125-126 (“Subordination to general creditors

is not necessarily indicative of a stock interest.”).

      Petitioner was the only supplier of cash to IM. It borrowed no money from

banks and thus had no “regular creditors.” While it is thus impossible to draw a

relative comparison between petitioner and other creditors, it is significant that pe-

titioner had, in absolute terms, none of the rights that a “regular creditor” would

have. There was no promissory note, no maturity date, no collateral, no protective

covenant, no personal guaranty, and no payment of interest. No “regular creditor”

would have lent funds to a loss-ridden company like IM on such terms. We find

that this factor, to the extent relevant here, supports characterizing the advances as

equity.

             7.     Parties’ Intent

      In considering this factor we examine whether the taxpayer and the corpora-

tion intended the advance to be debt or equity. Hardman, 827 F.2d at 1413. When

analyzing intent we look at the taxpayer’s actual intent when the advances were

made. A.R. Lantz Co., 424 F.2d at 1333. Our aim is to determine whether the

taxpayer intended to create a “definite obligation, repayable in any event.” See

Hewlett-Packard Co. v. Commissioner, T.C. Memo. 2012-135, 103 T.C.M. (CCH)
                                        - 25 -

[*25] 1736, 1752. Intent is a factual issue that is decided on the basis of all the

facts and circumstances in each case. See generally United States v. Uneco, Inc.

(In re Uneco, Inc.), 532 F.2d 1204, 1208 (8th Cir. 1976); Estate of Mixon, 464

F.2d at 402.

      Petitioner’s actions strongly suggest that he intended the advances to be

equity. He did not execute promissory notes for any of the advances at issue. He

received no interest on his advances and made no effort to collect interest or en-

force repayment of principal. Although IM recorded the advances as loans and

accrued interest on them, petitioner’s control over the company gave him ultimate

discretion to decide whether and how repayment would be made. In fact, he ex-

pected to be repaid, as a venture capitalist typically expects to be repaid, upon sale

of IM to a third party or a third-party investment in IM. This factor weighs in

favor of treating the advances as equity.

               8.   Inadequate Capitalization

      In considering this factor we examine whether the purported borrower had

“thin” capitalization. A company’s capitalization is relevant to determining the

level of risk associated with repayment. Bauer, 748 F.2d at 1369. Advances to a

business may properly be characterized as equity if its capitalization is sufficiently
                                        - 26 -

[*26] poor as to make repayment unlikely. Hardman, 827 F.2d at 1414; CMA

Consol., Inc., T.C. Memo. 2005-16.

      Petitioner urges that he should be regarded as having written off, on a FIFO

basis, the $8.55 million of advances that he made between May 2005 and June

2006, immediately after converting his previous $43.4 million of advances to pre-

ferred stock. At that point, he notes, the bulk of IM’s capital structure consisted of

preferred stock. He accordingly insists that IM was adequately capitalized at the

time he made those advances.

      As we explain more fully, infra pp. 37-39, we do not think petitioner’s

assessment of the situation is correct. During 2005-2009 he made dozens of

fungible cash advances totaling $43.04 million. In December 2009 he decided to

write off a portion of this sum, executing a certificate of debt forgiveness for $8.55

million and receiving a $34.5 million promissory note for the balance. In deter-

mining whether petitioner’s advances were debt or equity, we think it appropriate

to consider IM’s capitalization throughout this period.

      Between May 2005 and December 2009, petitioner’s aggregate cash ad-

vances ($43.04 million) roughly equaled the face value of IM’s preferred stock

($43.4 million). While this suggests that IM’s capitalization may have been

adequate, that fact would not seem compelling here. Normally, a large “equity
                                            - 27 -

[*27] cushion” is important to creditors because it affords them protection if the

company encounters financial stress: The creditors will not be at risk unless the

common and preferred shareholders are first wiped out. But because petitioner

himself supplied almost 100% of IM’s “equity cushion,” he would not derive

much comfort from the latter prospect. On balance, we conclude that this factor

slightly favors petitioner or is neutral.

             9.     Identity of Interest Between Creditor and Sole Shareholder

      In considering this factor we examine whether the advance is made by a sole

shareholder. Hardman, 827 F.2d at 1414. Petitioner was not IM’s sole share-

holder, but he controlled the company and during the relevant period owned be-

tween 78% and 92% of IM’s capital structure. There was thus a considerable,

albeit incomplete, identity of interest between petitioner in his capacities as owner

and alleged lender. Under these circumstances, there was not a “disproportionate

ratio between * * * [the] stockholder’s ownership percentage and the corporation’s

debt to that stockholder.” Am. Underwriters, Inc., 72 T.C.M. (CCH) at 1513. On

balance, we find that this factor slightly favors respondent or is neutral.

             10.    Payment of Interest

      In considering this factor we examine the source of interest payments.

Hardman, 827 F.2d at 1414. If no interest whatever is paid, that fact supports
                                       - 28 -

[*28] equity characterization. Am. Offshore, Inc. v. Commissioner, 97 T.C. 579,

605 (1991); Am. Underwriters, Inc., 72 T.C.M. (CCH) at 1518. IM made no

interest payments on any of the advances that petitioner made between February

2002 and December 2009. This fact strongly supports characterization of the

advances as equity.

            11.    Ability To Obtain Loans From Outside Lending Institutions

      The final factor we examine is whether the purported debtor could have

obtained similar funding from third-party lenders. Hardman, 827 F.2d at 1414.

Evidence that the business could not have obtained loans from outside sources

supports characterization of an insider’s advances as equity. Ibid.; Calumet

Indus., Inc., 95 T.C. at 287. We have recognized that lenders in related-party

contexts may offer more flexible terms than could be obtained (say) from a bank.

See C.M. Gooch Lumber Sales Co. v. Commissioner, 49 T.C. 649, 659 (1968),

remanded on a different issue, 406 F.2d 290 (6th Cir. 1969). Our primary inquiry

is whether the terms of the purported debt were a “patent distortion of what would

normally have been available” to the debtor in an arm’s-length transaction. See

Litton Bus. Sys., Inc., 61 T.C. at 379; Nestle Holdings, Inc. v. Commissioner, T.C.

Memo. 1995-441, aff’d in part, rev’d in part, 152 F.3d 83 (2d Cir. 1998); cf. Segel

v. Commissioner, 89 T.C. 816, 832-834 (1987) (stating that the benchmark for
                                       - 29 -

[*29] economic reality is whether a third-party lender would have made the

advances in substantially the same form and on substantially the same terms).

      The evidence is clear that no third party operating at arm’s length would

have lent $43 million to IM between May 2005 and December 2009 without

insisting (at a minimum) on promissory notes, regular interest payments, collateral

to secure the advances, and a personal guaranty from petitioner. Especially is that

so where (as here) the purported debtor was losing about $8 million a year and

could not fund its operations without petitioner’s monthly cash infusions.

      IM’s financial condition has been extremely precarious in every year since

its inception. Respondent’s expert, Mr. McCann, determined that IM had an ex-

tremely high risk of bankruptcy and that, without petitioner’s continued advances,

it would surely have ceased operations within one or two months. Under these

circumstances, no third-party lender would have lent $43 million to IM on the

terms petitioner did.

      In addition, petitioner continued to advance funds to IM even after he con-

cluded that its financial condition was dire enough to justify writing off some of

his advances. He advanced $600,000 to IM near the end of 2009 while his law-

yers were preparing documents to write down his prior advances. And he ad-

vanced another $37.75 million to IM during 2010-2013, again evidenced by no
                                       - 30 -

[*30] promissory notes. An unrelated lender would not have acted in this manner.

See Shaw, 106 T.C.M. (CCH) at 57 (concluding that shareholder’s advances to

family corporation were equity where she “left the spigot open” after its financial

position became more precarious). All in all, we conclude that this final factor

weighs in favor of equity characterization.5

      Our debt-vs.-equity determination does not depend merely on counting fac-

tors but on evaluating the factors as a whole. See Hardman, 827 F.2d at 1412.

Here, we find that 8 of the 11 factors favor characterizing petitioner’s advances as

equity, and several point very strongly in that direction. Two factors slightly favor

equity characterization or are neutral. And just one factor favors debt characteri-

zation and does so only slightly. Evaluating the factors overall we find that peti-

tioner’s advances, including the advances corresponding to his $8.55 million

writedown, were equity investments and not debt.


      5
        Petitioner introduced testimony from Mr. Bardoff that an “outside vendor”
advanced funds to IM in 2013 or 2014. Petitioner supplied no evidence as to: (1)
the identity of this vendor; (2) whether the vendor was a truly unrelated party; (3)
the amount of money it advanced; (4) whether it demanded a guaranty from peti-
tioner; or (5) the other terms on which it supposedly advanced the funds. We ac-
cordingly found this testimony to lack credibility and probative value. In any
event, the relevant question is whether an unrelated lender would have lent funds
to IM at the time petitioner did (i.e., between May 2005 and December 2009) on
the same terms as petitioner did. Petitioner introduced no evidence to support an
affirmative answer to that question.
                                        - 31 -

[*31] C.     Business vs. Nonbusiness Debt

      Our finding that petitioner’s advances constituted equity investments rather

than debt is sufficient to support our holding that he is not entitled to a bad debt

deduction. For the sake of completeness, however, we will consider his ability to

satisfy the other requirements for claiming a deduction against ordinary income

under section 166(a).

      “In the case of a taxpayer other than a corporation,” section 166(a) does not

apply where the debt is a “nonbusiness debt.” Sec. 166(d)(1). Although petitioner

claimed the bad debt loss deduction on a Schedule C for Synergenics, an LLC, he

does not contend that Synergenics actually advanced any of the funds at issue. All

of the advances were made by petitioner or his revocable trust. Thus, unless the

advances constituted a “business debt,” petitioner would not be entitled to a de-

duction under section 166(a).

      Section 166(d)(2) defines a business debt as “a debt created or acquired

* * * in connection with a trade or business of the taxpayer” or “a debt the loss

from the worthlessness of which is incurred in the taxpayer’s trade or business.”

To be eligible to deduct a loss as a business bad debt, a taxpayer must show that he

was engaged in a trade or business and that the debt was proximately related to his

trade or business. United States v. Generes, 405 U.S. 93, 96 (1972); Dagres v.
                                          - 32 -

[*32] Commissioner, 136 T.C. 263, 282 (2011); Putoma Corp., 66 T.C. at 673;

sec. 1.166-5(b), Income Tax Regs. To be engaged in a trade or business, the

taxpayer must participate in the activity with continuity and regularity, and his

primary purpose for engaging in the activity must be for income or profit.

Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). The management of one’s

investments, no matter how extensive, is not a “trade or business.” Whipple v.

Commissioner, 373 U.S. 193, 200 (1963).

      Respondent contends that petitioner made his advances in his capacity as an

investor. Petitioner contends that he made his advances in pursuit of his trade or

business as a “lender” or as a “promoter” of startup companies. We find neither of

petitioner’s contentions persuasive.

      Taxpayers who advance funds to controlled corporations often assert that

they are in the lending business. But “[t]he right to deduct bad debts as business

losses is applicable only to the exceptional situations in which the taxpayer’s ac-

tivities in making loans * * * [are] so extensive and continuous as to elevate that

activity to the status of a separate business.” Imel v. Commissioner, 61 T.C. 318,

323 (1973); Cooper v. Commissioner, T.C. Memo. 2015-191, 110 T.C.M. (CCH)

321, 321 (describing factors used to evaluate whether a taxpayer’s lending activity

rises to the level of a discrete trade or business).
                                         - 33 -

[*33] There is no support in the record for petitioner’s assertion that he was in the

business of lending money. He advanced more than $80 million to IM without ex-

ecuting promissory notes or collecting interest. No bank or other professional

lender operates in this fashion. Indeed, Mr. Bardoff acknowledged in an email

that petitioner “is not a traditional banker looking at liquid assets asking for reg-

ular repayment on loans. Rather he instead very actively seeks to increase the val-

ue of the assets they are trying to create.”

      Petitioner’s advances to IM were indisputably “extensive and continuous.”

But this shows only that IM was continuously in need of money, not that petitioner

was in the lending business. To establish that he was in the lending business peti-

tioner must show that he lent money, as banks do, with the expectation of making

a profit on his loans.

      But petitioner did not collect a penny of interest on his advances during the

eight-year period commencing March 2002. He likewise sought no repayment of

principal; indeed, he admitted that he hoped to be repaid, as a venture capitalist

typically hopes to be repaid, upon ultimate sale of IM to a third party or a third-

party investment in IM. This is not how lenders expect to make a profit. We find

no evidentiary support for the proposition that petitioner’s advances constituted “a
                                        - 34 -

[*34] debt created or acquired * * * in connection with a trade or business” of

lending money in which he was personally engaged. See sec. 166(d)(2)(A).

      Petitioner likewise failed to establish that he was engaged in the “trade or

business” of promoting biotech startup companies. See sec. 166(d)(2)(B). Con-

trary to his view, the Supreme Court’s opinion in Whipple does not support his

position. The taxpayer there formed a series of companies and advanced substan-

tial funds to one of them, a soft drink bottling company. Whipple, 373 U.S. at

195-196. That company made no payments to him during the years at issue, and

he eventually wrote off part of his advances as a business bad debt loss.

      The Supreme Court sustained the disallowance of his claimed deduction,

ruling that he was not in the “trade or business” of bottling or any other business

that would enable him to deduct the advances as a business bad debt. Id. at 197.

“Devoting one’s time and energies to the affairs of a corporation,” the Court ruled,

“is not of itself, and without more, a trade or business of the person so engaged.”

Id. at 202. And “[e]ven if the taxpayer demonstrates an independent trade or

business of his own, care must be taken to distinguish bad debt losses arising from

his own business and those actually arising from activities * * * [of] an investor

concerned with, and participating in, the conduct of the corporate business.” Ibid.
                                         - 35 -

[*35] In subsequent cases we have held that a taxpayer is not in the business of

being a “promoter” where he is entitled to no compensation other than a normal

investor’s return. See, e.g., Dagres, 136 T.C. at 281-282 (noting that a promoter

“receives not just a return on his own investment but compensation attributable to

his services”); Deely v. Commissioner, 73 T.C. 1081, 1095-1096 (1980) (stating

that, “in order for a promoter to be engaged in a trade or business for tax purposes

he must do so for ‘compensation other than the normal investor’s return’” (quoting

Millsap v. Commissioner, 46 T.C. 751, 756 (1966), aff’d, 387 F.2d 420 (8th Cir.

1968))); Ackerman v. Commissioner, T.C. Memo. 2009-80, 97 T.C.M. (CCH)

1392, 1414 (finding no trade or business as “promoter” where taxpayer did not

receive fees or commissions for providing advisory services). Here, petitioner

received no fees, commissions, or other compensation for his services. He ex-

pected to receive the return that equity investors normally hope for, namely, long-

term gain upon appreciation or sale of IM’s assets.

      A taxpayer may be able to show that he is engaged in business as a “pro-

moter” or “trader” if he establishes that his goal is to earn profits by “flipping”

assets, i.e., making quick and profitable sales of real estate, securities, or other

property. See, e.g., Assaderaghi v. Commissioner, T.C. Memo. 2014-33. Central

to these holdings is that the taxpayer aimed for profit from frequent short-term
                                        - 36 -

[*36] sales, not from patient long-term investment. “It is the early resale which

makes the profits income received directly for services, for the longer an interest is

held, the more profit becomes attributable to the successful operation of the

corporate business.” Deely, 73 T.C. at 1093-1094; see Millsap, 46 T.C. at 756-

757.

       These cases do not help petitioner. He did not incorporate IM to make a

profit from a quick and profitable sale. Quite the contrary: He testified that he

invested in IM as he had invested successfully in Chiron, recognizing that each

venture would take considerable time to develop into a successful business.

Petitioner fit the paradigm of a patient long-term investor, advancing funds to IM

continuously from 1999 through 2013 in the hope that his investment would

eventually pay off. These are not the actions of a “promoter” or “trader.”

       In sum, we find that petitioner was not in the “trade or business” of lending

money or promoting companies. If his advances were considered debt, they were

neither debt “created or acquired * * * in connection with” a trade or business

conducted by him nor debt the loss from the worthlessness of which was incurred

in any trade or business he conducted. Sec. 166(d)(2)(A) and (B). At best, the ad-

vances would give rise to a nonbusiness bad debt which, upon becoming worth-

less, would generate a short-term capital loss. See sec. 166(d)(1)(B).
                                        - 37 -

[*37] D.     Worthlessness During 2009

      Assuming arguendo that petitioner’s advances were debts and constituted

business debts, he would be entitled to a deduction for 2009 only if he established

worthlessness during 2009. Section 166(a)(1) allows a deduction for a business

bad debt loss if the debt “becomes worthless within the taxable year.” In the case

of a partially worthless debt, section 166(a)(2) provides that, “[w]hen satisfied that

a debt is recoverable only in part, the Secretary may allow such debt, in an amount

not in excess of the part charged off within the taxable year, as a deduction.”

      To analyze this issue we must first decide whether petitioner’s advances

constituted separate individual “debts” (several of which allegedly became wholly

worthless) or a single aggregate “debt” (which allegedly became worthless in

part). Petitioner contends that each of his advances was a separate “loan” and that

he decided to write off some of the oldest loans that he made during 2005-2006.

       To support his position he cites KTA-Tator, Inc. v. Commissioner, 108

T.C. 100 (1997). We there held that, for purposes of section 7872, a corporate

taxpayer’s advances to related parties were separate loans, each of which consti-

tuted an “extension of credit.” Id. at 103. Relying heavily on the legislative his-

tory of section 7872 and proposed regulations interpreting it, we held that the

taxpayer’s advances were more akin to separate transfers of money giving rise to
                                         - 38 -

[*38] repayment rights than to an open line of credit upon which the transferees

could draw at any time. Ibid.

      We find this case inapposite here. The only question we addressed in KTA-

Tator was whether the advances were separate extensions of credit “for purposes

of section 7872,” which governs the treatment of loans with below-market interest

rates. 108 T.C. at 103. And petitioner’s advances, unlike those in KTA-Tator,

were clearly akin to “an open line of credit.” Id. at 102. They were not evidenced

by prommissory notes but were open-account advances of cash.

      Treating petitioner’s advances as separate loans might be appropriate if they

were evidenced by promissory notes that had different maturities, different interest

rates, or different levels of creditor protection in terms of covenants or collateral.

But as Mr. Bardoff admitted, petitioner regarded all of his advances as fungible;

he believed it unnecessary to execute promissory notes because he was the only

person funding IM. Indeed, Mr. Bardoff’s plan to write off the advances on a

FIFO basis, as one would record the disposition of inventory, underscores the

fungibility of the advances. Petitioner did not contend that his 2005 and 2006

advances were especially risky, and he could not plausibly make that argument

because he advanced all the money on exactly the same terms.
                                        - 39 -

[*39] The economic reality is that petitioner advanced $43.04 million to IM on an

open account, as needed by IM, as if he were extending a line of credit. Like a

bank line of credit, this is properly regarded as a single aggregate debt. Mr. Bard-

off confirmed the aggregate nature of the advances by stating his belief that peti-

tioner was making a “partial write down” of this alleged debt.

      We accordingly must decide whether petitioner met the requirements for

establishing for 2009 a partially worthless debt. Sec. 166(a)(2). The year in

which a purported debt becomes worthless must be fixed by identifiable events

that make it reasonable for the lender to abandon any hope of recovery. Crown v.

Commissioner, 77 T.C. 582, 598 (1981). Whether a debt has become worthless is

a facts-and-circumstances determination. Sec. 166(a)(2); sec. 1.166-2(a), Income

Tax Regs.

      A taxpayer can establish worthlessness by showing that a debt has neither

current nor potential value. Dustin v. Commissioner, 53 T.C. 491, 501 (1969),

aff’d, 467 F.2d 47 (9th Cir. 1972). There is no standard test or formula for deter-

mining worthlessness; relevant facts include the debtor’s solvency and the lender’s

collection efforts. See Aston v. Commissioner, 109 T.C. 400, 415 (1997); sec.

1.166-2(a), Income Tax Regs. Other relevant factors may include decline in the

value of collateral, the debtor’s earning capacity, events of default, the debtor’s
                                        - 40 -

[*40] refusal to pay, the debtor’s lack of assets, actions the lender took to pursue

collection, and subsequent dealings between the parties. Am. Offshore, Inc., 97

T.C. at 594. No single factor is conclusive. Ibid.

      The taxpayer’s burden is especially great where he seeks to deduct a par-

tially worthless debt. The statute affords the IRS discretion on this point, pro-

viding that “the Secretary may allow such debt * * * as a deduction” if he is

“satisfied that a debt is recoverable only in part.” Sec. 166(a)(2) (emphasis add-

ed). “Before a taxpayer may deduct a debt in part, he must be able to demonstrate

to the satisfaction of the district director the amount thereof which is worthless

and the part thereof which has been charged off.” Sec. 1.166-3(a)(2)(iii), Income

Tax Regs.6

      The Commissioner’s disallowance of a deduction under section 166(a)(2)

will be sustained so long as he exercises his discretion reasonably. Brimberry v.

Commissioner, 588 F.2d 975, 977 (5th Cir. 1979), aff’g T.C. Memo. 1976-209;

Portland Mfg. Co. v. Commissioner, 56 T.C. 58, 72 (1971), aff’d on other

grounds, 35 A.F.T.R. 2d (RIA) 75-1439, 75-1 U.S. Tax Cas. (CCH) para. 9449


      6
        Banks receive more liberal treatment. A partially charged-off loan is de-
ductible by a bank if the charge-off is (among other things) “[i]n accordance with
established policies” of the bank’s regulator. Sec. 1.166-2(d)(1), Income Tax
Regs.
                                        - 41 -

[*41] (9th Cir. 1975). His exercise of discretion will not be set aside unless it is

arbitrary and unreasonable. Ark. Best Corp. & Subs. v. Commissioner, 800 F.2d

215, 221 (8th Cir. 1986), aff’g in part, rev’g in part 83 T.C. 640 (1984), aff’d on

other grounds, 485 U.S. 212 (1988).

      Petitioner has not made the showing that the statute and the regulations re-

quire. First, he has not established to the Commissioner’s satisfaction, or ours, the

amount of the debt that was worthless at year-end 2009. Sec. 1.166-3(a)(2)(iii),

Income Tax Regs. The $8.55 million number he chose for the writedown (reduced

from the $10 million “placeholder” figure Mr. Bardoff had used initially) appears

to have been selected because it approximated the income petitioner realized

earlier in 2009 from another of his startup companies. He made no effort to tie

this writedown to IM’s actual financial condition or ability to repay.

      Second, petitioner did not show that any portion of his advances became

worthless during 2009. He appears to have had a reasonable hope of recovering

on his investments; that is presumably why he continued to advance another

$37.75 million to IM during 2010-2013. See Crown, 77 T.C. 582, 598 (1981);

Flood v. Commissioner, T.C. Memo. 2001-39, 81 T.C.M. (CCH) 1175, 1180 (“A

debt becomes worthless in the tax year in which a creditor, using sound business

judgment, abandons all reasonable hope of recovery[.]”); sec. 1.166-2(a), Income
                                       - 42 -

[*42] Tax Regs. Conversely, if any portion of the debt was worthless, petitioner

did not show that it became worthless in 2009 rather than in some earlier year.

See Hirsch v. Commissioner, 124 F.2d 24, 31 (9th Cir. 1941) (“A taxpayer should

not be permitted to close his eyes to the obvious, and to carry accounts on his

books as good when in fact they are worthless, and then deduct them in a year

subsequent to the one in which he must be presumed to have ascertained their

worthlessness.” (citing Avery v. Commissioner, 22 F.2d 6, 7-8 (5th Cir. 1927))),

aff’g 42 B.T.A. 566 (1940).

      In seeking an “identifiable event” that would cause partial worthlessness

during 2009 in particular, petitioner and his expert seize upon the supposed col-

lapse of IM’s discussions with Google. But those discussions were proceeding

apace through the end of 2009, complete with two Powerpoint presentations by

petitioner to Google executives. The email correspondence convinces us that

Google during 2009 was genuinely interested in the possibility of integrating IM’s

products into its applications.

       It was not until March 2010 that Google reached an internal “no go” deci-

sion about partnering with IM, and that decision was not communicated to IM un-

til June 2010. Petitioner’s assertion that talks with Google had totally collapsed

by year-end 2009 is hard to reconcile with these facts or with his upbeat assess-
                                       - 43 -

[*43] ment, in a December 2009 email to IM employees, that “convergent forces”

had “created great potential for change” and had “create[d] an unusual opportunity

for consumer oriented approaches.”

      Petitioner relies heavily on Mr. MacKenzie’s expert report to support his

position that IM’s value had declined from $55 million at year-end 2008 to $14

million at year-end 2009. We agree with Mr. McCann, respondent’s expert, that

Mr. MacKenzie’s report is flawed in several respects. For 2008 Mr. MacKenzie

relied heavily on management’s revenue projections for that year, which were

made in 2007. This reliance was clearly misplaced. The worldwide financial

crisis that began during 2007 peaked in 2008, leading to a massive lack of liquid-

ity in the financial system and leaving even stable companies starved for credit.

The revenue projection that IM made in 2007 could not reasonably be taken at

face value; in fact, IM’s 2008 revenues were 98% below that target.

      For 2009 Mr. MacKenzie relied heavily on the purported collapse of IM’s

partnership discussions with Google as his basis for determining that IM’s value

had declined by 74% from year-end 2008. As noted earlier, we find no factual

support for this hypothesis; IM’s discussions with Google were ongoing at year-

end 2009 and did not turn south until mid-2010. Far from the 74% decline in

value posited by Mr. MacKenzie, we find Mr. McCann’s assessment more plau-
                                          - 44 -

[*44] sible. Using conventional financial metrics, he concluded that IM’s

financial condition at year-end 2009 was not materially different from its financial

condition at year-end 2008.

         In sum, the IRS did not abuse its discretion in determining that petitioner

was not entitled to a deduction of $8.55 million for a partially worthless debt for

2009. Even if petitioner established that his advances were debt and that this debt

was a business debt, he did not meet the requirements for deducting a partially

worthless debt under section 166(a)(2) and section 1.166-3(a)(2)(iii), Income Tax

Regs.7

II.      Accuracy-Related Penalty

         The Code imposes a 20% penalty upon the portion of any underpayment of

income tax that is attributable (among other things) to “negligence” or any “sub-

stantial understatement of income tax.” Sec. 6662(a) and (b)(1) and (2). “Negli-

gence” is defined as “any failure to make a reasonable attempt to comply” with the

provisions of the Code. Sec. 6662(c). An understatement of income tax is “sub-

stantial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown

on the return. Sec. 6662(d)(1)(A).

         7
        Given our disposition, we need not address respondent’s contention that
petitioner’s deduction should be disallowed because the documents implementing
the writedown were executed in February or March 2010 and backdated to 2009.
                                       - 45 -

[*45] Under section 7491(c) the Commissioner bears the burden of production

with respect to the liability of an individual for any penalty. See Higbee v. Com-

missioner, 116 T.C. 438, 446 (2001). Respondent met his burden as to a sub-

stantial understatement of income tax by showing that petitioner was not entitled

to the $8.55 million bad debt deduction claimed on his 2009 return. The under-

statement of income tax attributable to that improper deduction exceeds 10% of

the tax required to be shown on the return. The burden thus shifts to petitioner to

prove that the penalty does not apply. See id. at 447.

      A taxpayer may avoid the accuracy-related penalty by showing that he acted

with reasonable cause and in good faith. Sec. 6664(c)(1). Reasonable cause re-

quires that the taxpayer exercised ordinary business care and prudence as to the

disputed item. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98

(2000), aff’d, 299 F.3d 221 (3d Cir. 2002). Good faith means, among other things,

an honest belief and an intent to perform all lawful obligations. E.g., United

States v. Hirschfeld, 964 F.2d 318, 322 (4th Cir. 1992).

      Both of these determinations are made on a case-by-case basis, taking into

account all relevant facts. Sec. 1.6664-4(b)(1), Income Tax Regs. Circumstances

that may indicate reasonable cause and good faith include (among other things) an

honest misunderstanding of fact or law that is reasonable in light of all the circum-
                                        - 46 -

[*46] stances, including the taxpayer’s experience, knowledge, and education.

The most important factor is the taxpayer’s efforts to assess his tax liability

correctly. Ibid.

      A taxpayer may demonstrate reasonable cause and good faith by showing

reliance on the advice of a tax professional, such as an accountant or a lawyer, re-

garding a particular item’s tax treatment. Id. para. (c)(1). To rely in good faith on

the advice of a professional, the taxpayer must show that: (1) the adviser “was a

competent professional who had sufficient expertise to justify reliance”; (2) “the

taxpayer provided necessary and accurate information to the adviser”; and (3) “the

taxpayer actually relied in good faith on the adviser’s judgment.” Neonatology

Assocs., P.A., 115 T.C. at 99.

      Before turning to the Neonatology test, we first consider whether petitioner

had “substantial authority” for his return position. See sec. 6662(d)(2)(B)(i). He

contends that his characterization of the advances as debt is supported by the test

enunciated by the Ninth Circuit in Hardman. See sec. 1.6662-4(d)(2) and (3), In-

come Tax Regs. We do not agree. Only one of the 11 Hardman factors supports

debt characterization, and it does so only slightly; most of the other factors strong-

ly support equity treatment. The other cases on which petitioner relies are inap-
                                        - 47 -

[*47] posite to the facts of this case or are irrelevant. The weight of authority

supporting equity treatment for petitioner’s advances is overwhelming.

      We now consider whether petitioner has established a “reliance on profes-

sional advice” defense to the accuracy-related penalty under the Neonatology test.

Petitioner must first show that he relied on “a competent professional who had

sufficient expertise to justify reliance.” See Neonatology Assocs., P.A., 115 T.C.

at 99. Petitioner contends that he relied on advice from Mr. Bardoff, a

Synergenics vice president, and Jason Graham, his personal accountant. We find

that Mr. Graham, a certified public accountant, is a competent tax professional.8

      The second prong of the Neonatology test requires the taxpayer to show that

he provided “necessary and accurate information” to the professional. Ibid.; see

Ma-Tran Corp. v. Commissioner, 70 T.C. 158, 173 (1978). Mr. Bardoff reviewed

IM’s financial condition and researched the deductibility of bad debt losses. He

then drafted memoranda and emails for Mr. Graham’s review. On the basis of the

information Mr. Bardoff provided to him, Mr. Graham agreed that a portion of the

advances could be written off.


      8
       Respondent contends that petitioner could not reasonably rely on Mr.
Halasz (his personal attorney), on Matthew Sanders (IM’s CEO), or on IM’s tax
return preparers. Because petitioner does not contend that he relied on any of
these people, we need not address the application of the Neonatology test to them.
                                        - 48 -

[*48] We find that Mr. Bardoff omitted or misstated several important facts in his

communications with Mr. Graham. Mr. Bardoff erroneously told Mr. Graham that

promissory notes existed for the advances and that IM had paid interest on them.

(These facts are critical for at least three of the Hardman factors). Petitioner knew

that there were no promissory notes and knew that he never received any interest

payments, but at no point did he correct Mr. Bardoff’s misstatements. We find

that petitioner did not supply “necessary and accurate information” to Mr.

Graham, the tax professional on whom he allegedly relied. See Neonatology

Assocs., P.A., 115 T.C. at 99. We accordingly conclude that petitioner cannot

avail himself of the “reliance on professional advice” defense to the accuracy-

related penalty.9

      To reflect the foregoing,


                                                 Decision will be entered for

                                       respondent.




      9
       Because we find that petitioner did not supply accurate information to his
tax adviser, we need not determine whether he “actually relied in good faith on the
adviser’s judgment.” Neonatology Assocs., P.A., 115 T.C. at 99.
