                         T.C. Memo. 1997-492



                       UNITED STATES TAX COURT



                 DONALD R. MARTIN, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 19374-94.                  Filed October 29, 1997.



     Donald R. Martin, pro se.

     Julie M.T. Foster, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:   Respondent determined that petitioner is

liable for income tax deficiencies and additions to tax as

follows:

                                     Additions to tax
           Year       Deficiency     Sec. 6651(a)(1)
           1990       $92,776            $21,479
           1991        41,922               --
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     Petitioner caused The Activewear Company, Inc. (Activewear),

a corporation of which he was a 50-percent shareholder, to lend

money to an unrelated party, Randy Jackson (Jackson), to use in

Jackson's businesses.    Jackson did not fully repay the loans.

The issues for decision are:

     1.   Whether the amounts Activewear lent, less the amounts

Jackson repaid (a net of $318,000 for 1990 and $126,094 for

1991), were taxable to petitioner as constructive dividends from

Activewear.   We hold that they were not.

     2.   Whether the value of property Jackson provided to

petitioner as security was income to petitioner in 1990 and 1991.

We hold that it was not.

     3.   Whether petitioner is liable for an addition to tax

under section 6651(a)(1) for late filing of his 1990 Federal

income tax return.   We hold that he is.

     Section references are to the Internal Revenue Code in

effect in the years in issue.    Rule references are to the Tax

Court Rules of Practice and Procedure.

                           FINDINGS OF FACT

     Some of the facts are stipulated and are so found.

A.   Petitioner

     Petitioner lived in Athens, Georgia, when he filed the

petition in this case.
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B.   Activewear

     Petitioner met J. Douglas Waddell (Waddell) in 1976 when

they worked together at a sewing plant in Athens, Georgia.

Around 1984, petitioner asked Waddell to join him in starting a

sewing business.    Waddell agreed.

     Petitioner and Waddell formed a sewing business called

Activewear in 1985.    Petitioner and Waddell each owned 50 percent

of Activewear.    Activewear manufactured pants, skirts, and

shorts.   Petitioner was Activewear's secretary/treasurer and was

primarily responsible for its financial and business activities.

Petitioner wrote most of the checks from the Activewear account

from 1985 to 1991.    He also handled most of the correspondence

for Activewear.    Waddell was Activewear's president and was

primarily responsible for personnel and production.    Petitioner

and Waddell received equal salaries and bonuses.    Waddell could

use the checkbook and inspect the accounting records at anytime.

He occasionally wrote Activewear checks when petitioner was not

available.

     For the first 5 or 6 years Activewear was in business,

petitioner and Waddell each had salaries of more than $100,000

per year.    In 1990 and 1991, Activewear was financially

successful.
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C.   Jackson

     Jackson had been petitioner's friend since petitioner

attended college.    Waddell did not know Jackson.

     In 1985, Jackson gave Activewear a short-term loan to help

it meet its payroll.    Activewear repaid the loan.    Jackson

continued to make short-term loans whenever Activewear had a

cash-flow problem.    Activewear always repaid those loans.

     In the years in issue, Jackson owned Greensboro Ford and

Carey Station, Inc. (Jackson's corporations).     Jackson's wife was

the majority shareholder in a campground in Tallulah Falls,

Georgia.

D.   Activewear's Loans to Jackson's Corporations

     1.    Initial $50,000 Loan

     Around November 1989, Jackson's corporations began to have

cash-flow difficulties.     Jackson asked petitioner for a short-

term loan.     Jackson offered to repay the loan in a week, to pay

10-percent interest, and to provide three classic automobiles as

collateral.    Petitioner believed Jackson was a good credit risk.

Activewear had funds available to make the loan.      Petitioner

asked Waddell to authorize Activewear to lend $50,000 to

Jackson's corporations.     Waddell approved the loan.   Activewear

then lent Jackson's corporations $50,000 based on an oral
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agreement.    Jackson repaid the $50,000 loan on time and paid

Activewear 10-percent interest on the loan.

     2.     Additional Loans

     Activewear then made more short-term loans to Jackson's

corporations.    Petitioner wrote checks payable to Jackson or his

corporations drawn on Activewear's account.    Jackson or his

corporations repaid the loans to Activewear, usually in less than

4 days with interest at 10 percent.     Petitioner did not discuss

the loans to Jackson with Waddell after the first $50,000 loan.

Petitioner wrote the checks to Jackson on the Activewear checking

account and properly recorded each loan in Activewear's account

books.    There were no written loan agreements.

     Petitioner also personally lent $100,000 to Jackson at a

time not specified in the record.    Petitioner borrowed that money

from a retired friend, Norman Hardin (Hardin).     Hardin knew that

petitioner was going to lend the money to Jackson.    As security

for that loan, in February 1991, Jackson gave petitioner a fourth

or fifth mortgage to a restaurant building.    A neon light caused

a fire in the restaurant at a date not specified in the record.

     In 1989 or 1990, Jackson gave petitioner two blank

promissory notes that he had signed as security for the loans

Activewear and petitioner made to him or his corporations.      One

note was for Activewear's loans to Jackson and the other note was
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for petitioner's personal loan to Jackson.    These notes were to

be completed by petitioner or Activewear if Jackson or his

corporations did not repay the loans.

     Petitioner recorded all of the loans in Activewear's books.

Petitioner wrote a check for every loan and completed the check

stub in the Activewear checkbook.    Activewear made short-term

loans to Jackson until May 1991.

     3.   Jackson's Repayment History

     Jackson timely repaid all of the Activewear loans for 2½

years until about August 1990.    At that time, his repayments

began to be late and some of his checks bounced.

     In 1990, Activewear lent $2,070,900 to Jackson's

corporations and Jackson's corporations repaid $1,752,900.

Activewear continued to lend money to Jackson because petitioner

believed that Jackson would be able to repay the loans if he

could continue to operate.   In 1991, petitioner lent $958,880 to

Jackson's corporations and Jackson's corporations repaid

$832,786.06.   Jackson's outstanding loan balances were $318,000

for 1990 and $126,094 for 1991.
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E.   Petitioner's Loans from Trust Co.

     1.      Loans to Petitioner

     In 1990, petitioner borrowed $15,000 from Trust Co. Bank of

Northeast Georgia (Trust Co.) to increase the inventory in a

convenience store that he owned.

     Activewear began to have cash-flow problems around April

1991, in part because Jackson and his corporations had not repaid

the loans to Activewear.     Petitioner asked Trust Co. to lend

money to petitioner for Activewear to use as operating capital.

Trust Co. agreed to lend $50,000 to petitioner in April 1991 and

$15,000 in July 1991.     Thus, at that time, petitioner had loans

totaling $80,000 from Trust Co.       The $50,000 and $15,000 loans

were the personal liability of petitioner.       Petitioner

immediately transferred the proceeds of these loans to

Activewear.     Petitioner recorded these amounts on Activewear's

books as loan repayments by Jackson.

     2.      Collateral for Loans

     In October 1991, when the $50,000 and $15,000 April and July

1991 loans were due, Tom Wilson, vice president of Trust Co.,

asked petitioner to consolidate them with his earlier $15,000

loan, and to provide collateral for the $80,000 consolidated

loan.     Petitioner gave Trust Co. collateral consisting of his own

stock, mutual funds, and other marketable securities with a

market value of $27,291 and an $80,000 second mortgage to his
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personal residence with the understanding that, if other security

interests provided by Jackson (described next) had sufficient

value, Trust Co. would return petitioner's property.    Petitioner

had about $100,000 in equity in his home at the time.

     Petitioner asked Jackson to provide collateral for the

consolidated loan.   Jackson owned a house financed by a first

mortgage from First Federal in Winder, Georgia.   The first

mortgage was $202,000.   Jackson sold the house to Ken and

Victoria O'Key (the O'Keys) and took back a second mortgage.     The

O'Keys agreed to pay Jackson, who would then make payments to

First Federal on the first mortgage and keep the payments on the

second mortgage.   Jackson assigned the second mortgage to

petitioner which petitioner gave to Trust Co.   Jackson also gave

petitioner the following security interests which petitioner gave

to Trust Co.:   (a) A second deed from Neighbors Group, Inc., for

seven tracts of land in Deer Lake Estates; and (b) a second deed

to secure debt (not otherwise described in the record) on a small

strip shopping mall in Statham, Georgia.   Petitioner also gave

Trust Co. the fourth or fifth mortgage on the restaurant building

that Jackson had given petitioner in February 1991.

     None of the security interests were in foreclosure when they

were assigned to petitioner.   Petitioner used them as collateral

for the $80,000 consolidated loan he made in October 1991.
                                - 9 -


       All security interests Jackson gave to petitioner were

signed over to petitioner, not Activewear.     Petitioner gave the

security interests to Trust Co. when he received them from

Jackson, except for the one for the restaurant building which he

gave to Trust Co. later.

       Petitioner was personally liable for these bank loans.

F.   Civil Lawsuit Against Petitioner

       In early 1991, Greg Garcia (Garcia), Activewear's tax

attorney, told Waddell that petitioner was lending Activewear's

money to Jackson and that Jackson usually repaid it in 2 to 4

days.    Garcia told Waddell that Garcia would tell Waddell if

repaying the loans ever became a problem.

       Around April 1991, Trust Co. told Waddell that Jackson had

insufficient funds for two checks.      Early in 1992, Trust Co. told

Waddell that more than $200,000 had been taken from Activewear.

Garcia advised Waddell to retain a lawyer, and referred him to

one.    Waddell did not ask petitioner for an explanation.

Instead, he hired a lawyer.    At that time, Waddell believed that

petitioner had embezzled money from Activewear.     In 1992, Waddell

sued petitioner in the Superior Court of Athens-Clarke County,

Georgia, on behalf of himself and Activewear to recover the

amounts Jackson had not repaid.    In the same lawsuit, petitioner

sued Jackson's corporations to recover the amounts Jackson had

not repaid.    Waddell deposed all parties and investigated the

case thoroughly.
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      The parties settled the lawsuit without trial on May 24,

1993.     Petitioner agreed to pay $155,000.   He borrowed money to

make this payment, and gave his house and securities as

collateral.

      Petitioner was never criminally charged for any conduct

relating to Activewear.

G.    Petitioner's Use of the O'Key Property in 1993-94

        In 1992, Jackson filed for bankruptcy protection under

Chapter 11.     The O'Keys stopped paying Jackson.   Petitioner told

the O'Keys that they must make all the payments that were due or

move out.     In August 1993, they moved out and petitioner moved

in.     He lived there rent-free until August 1994 when Jackson's

bankruptcy proceedings ended and the bank foreclosed on the

house.     The Resolution Trust Corp. sold the house at auction for

$152,000.

H.      Petitioner's Income Tax Returns and Respondent's
        Determination

        Petitioner received an extension of time to file his 1990

income tax return until October 15, 1991.      Petitioner filed his

income tax returns for 1990 and 1991 on August 26, 1992.     He

filed married filing separately.

        On his income tax return for 1990, petitioner attached a

disclosure statement which said:

        2.   The taxpayer made unauthorized loans from
        Activewear corporate funds in the amount of $2,070,900,
        less repayments of $1,752,900 = $318,000 balance due.
        The corporation is pursuing the taxpayer with charges
                                - 11 -


     of embezzlement. The taxpayer's assertion is that the
     loan amounts outstanding are due to the corporation and
     not to him personally and therefore is not including
     the balance due of $318,000 in his taxable income.

     On his income tax return for 1991, petitioner attached a

disclosure statement which said:

     2.   The taxpayer made unauthorized loans from
     Activewear, Inc. in the amount of $958,880 less
     repayments of $832,786 = $126,094 balance due. The
     corporation is pursuing the taxpayer with charges of
     embezzlement. The taxpayer's assertion is that the
     loan amounts outstanding are due to the corporation and
     not to him personally and therefore he is not including
     the balance due of $126,094 in taxable income.

     Respondent determined that the $318,000 in 1990 and $126,094

in 1991 was income to petitioner.    Respondent also determined

that petitioner filed his 1990 income tax return late.

                                OPINION

A.   Positions of the Parties

     Respondent contends that petitioner misappropriated funds by

writing unauthorized checks from Activewear to Jackson's

corporations in 1990 and 1991.    Alternatively, respondent

contends that the unpaid balances were constructive dividends

paid by Activewear to petitioner.    Thus, respondent contends that

the unpaid loan balances of $318,000 in 1990 and $126,094 in 1991

to Jackson's corporations are income to petitioner.    Respondent

also contends that the security interests Jackson gave to

petitioner for the Activewear loans were income to petitioner.

     Petitioner contends that the unpaid amounts were not income

to him because the transfers were bona fide business loans from
                                  - 12 -


Activewear to Jackson.   Petitioner also contends that the

security interests are not taxable to him because he received no

benefit from them in the years in issue.        For reasons discussed

next, we agree with petitioner.

B.   Whether Petitioner Misappropriated Funds From Activewear

     Respondent contends that petitioner misappropriated the

funds Activewear lent to Jackson and his corporations.        We

disagree.    When he filed his lawsuit, Waddell thought that

petitioner had embezzled money from Activewear.        However, after

he investigated the matter, he believed that petitioner did not

benefit from the loans to Jackson.         Petitioner had no reason to

believe that Waddell would not approve the advances because

Waddell had approved the first one, and he did nothing to conceal

the loan records from Waddell.      Petitioner credibly testified

that he received no benefit from Activewear's loans to Jackson.

Petitioner was not criminally charged for his conduct related to

Activewear.    We do not believe that he misappropriated any funds

from Activewear.

     Respondent contends that the transfers of funds from

Activewear to Jackson's corporations were not loans because there

were no written agreements and Jackson provided no collateral or

other security.    We disagree.    Respondent concedes that the first

$50,000 check was a loan even though it was based on an oral

agreement.    The later transfers were also loans based on oral

agreements.
                              - 13 -


C.   Whether the Unpaid Balances of the Loans From Activewear to
     Jackson's Corporations Are Constructive Dividends to
     Petitioner

     Respondent contends that the unpaid balances of Activewear's

advances to Jackson or his corporations were constructive

dividends to petitioner.   We disagree.

     Gross income includes dividends.     Sec. 61(a)(7).   A dividend

is a distribution of property by a corporation to its

shareholders from its earnings and profits.     Sec. 316(a).   A

shareholder receives a constructive dividend to the extent of the

corporation's earnings and profits if the corporation pays a

personal expense of its shareholder or the shareholder uses

corporate property for a personal purpose.     Secs. 301, 316;

Falsetti v. Commissioner, 85 T.C. 332, 356-357 (1985); Henry

Schwartz Corp. v. Commissioner, 60 T.C. 728, 743-744 (1973).

Whether a shareholder receives a constructive dividend is a

question of fact.   Hagaman v. Commissioner, 958 F.2d 684, 690-691

(6th Cir. 1992), affg. and remanding T.C. Memo. 1990-655; Loftin

& Woodard, Inc. v. United States, 577 F.2d 1206, 1214-1215 (5th

Cir. 1978).

     Petitioner did not use or receive any benefit from the

unpaid balance of Activewear's loans to Jackson or his

corporations.   Petitioner used his own funds to compensate for

Jackson's failure to repay Activewear.     Petitioner reasonably

believed that it was in Activewear's interest to help Jackson and

to earn interest for Activewear.
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     Respondent relies on Crowley v. Commissioner, 962 F.2d 1077

(1st Cir. 1992), affg. T.C. Memo. 1990-636, for the proposition

that the unpaid funds transferred from Activewear to Jackson were

constructive dividends to petitioner.   We disagree.    In Crowley

v. Commissioner, supra at 1078-1079, the taxpayer used corporate

funds; here, petitioner did not use the unpaid loan balances.

The taxpayer in Crowley did not intend to repay the funds at

issue, id. at 1081; here, petitioner and Activewear expected

Jackson to repay the loans.

     Respondent contends that the facts in this case differ from

those in Gilbert v. Commissioner, 552 F.2d 478 (2d Cir. 1977),

revg. T.C. Memo. 1976-104, in which we held that corporate

payments were not constructive dividends.   We disagree.   The

facts are stronger for petitioner in this case than they were for

the taxpayer in Gilbert.   The taxpayer in Gilbert v.

Commissioner, supra at 479, 481, withdrew funds from a

corporation which he intended and expected to repay.    He used

funds in part to benefit the corporation.   Id. at 481.    The U.S.

Court of Appeals for the Second Circuit held that the withdrawals

were not income to the taxpayer.   Here, petitioner did not

personally withdraw funds or use them for his own benefit.

Petitioner reasonably believed that Jackson would repay

Activewear.
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     Respondent contends that Activewear's transfers to Jackson

were personal because Activewear was not in the lending business.

We disagree.    Respondent cites no authority for this contention.

     We conclude that the amounts that Jackson owed to Activewear

in 1990 and 1991 were not constructive dividends to petitioner.

D.   Whether Petitioner Received Income From Security Interests
     Provided by Jackson

     Jackson assigned four security interests to petitioner and

petitioner used the four security interests to secure an $80,000

personal loan.     Respondent contends in respondent's pretrial

memorandum, opening statement, and posttrial brief that

petitioner received $402,600 in income from the four security

interests.     We disagree.

     Respondent did not raise the theory that petitioner received

income from the security interests in the notice of deficiency.

A theory not raised in the notice of deficiency is new matter if

it increases the original deficiency or requires the taxpayer to

present different evidence.     Rule 142(a); Vetco, Inc. v.

Commissioner, 95 T.C. 579, 588 (1990); Achiro v. Commissioner, 77

T.C. 881, 890 (1981); Estate of Falese v. Commissioner, 58 T.C.

895, 898-899 (1972).     To contest this theory, petitioner would

have needed to introduce evidence relating to his consolidated

loan from Trust Co. and the four security interests.     The four

security interests were not collateral for Activewear's loans to

Jackson.   Petitioner was not required to offer that evidence to
                              - 16 -


defend against respondent's determination in the notice of

deficiency that the unpaid balances in 1990 and 1991 were

misappropriations and income to petitioner.   Respondent bears the

burden of proof.   Rule 142(a).

     The four security interests were not collateral for the

Activewear loans to Jackson and his corporations; they secured

petitioner's consolidated $80,000 personal loan, $65,000 of which

petitioner used to provide operating capital for Activewear.

Thus, petitioner used the loan proceeds primarily for Activewear.

Petitioner used about $27,000 of his marketable securities and a

house with about $100,000 in equity as collateral for the

consolidated loan.   This is more than enough collateral for the

$15,000 loan that petitioner used for inventory for his

convenience store that was part of the $80,000 consolidated loan.

     Respondent points out that petitioner benefited from living

in the O'Key house for 1 year rent-free.   That year was August

1993 to August 1994.   The years in issue are 1990 and 1991.

Respondent has not shown how living in the house in 1993 and 1994

had value in the years in issue.   Also, respondent did not prove

the value of the benefit petitioner received.

     We conclude that respondent has not shown that petitioner

received any income from security interests in 1990 or 1991.
                              - 17 -


E.   Whether Petitioner Is Liable for the Addition to Tax for
     Failure to Timely File His 1990 Return

     Respondent determined that petitioner is liable for the

addition to tax for failure to timely file his income tax return

for 1990.   Sec. 6651(a).

     Section 6651(a)(1) imposes an addition to tax of up to 25

percent of the tax required to be shown on the return for failure

to timely file Federal income tax returns unless the taxpayer

shows that the failure was due to reasonable cause and not

willful neglect.   United States v. Boyle, 469 U.S. 241, 245

(1985); Baldwin v. Commissioner, 84 T.C. 859, 870 (1985); Davis

v. Commissioner, 81 T.C. 806, 820 (1983), affd. without published

opinion 767 F.2d 931 (9th Cir. 1985).

     To prove reasonable cause, a taxpayer must show that he or

she exercised ordinary business care and prudence and

nevertheless could not file the return when due.   Crocker v.

Commissioner, 92 T.C. 899, 913 (1989); sec. 301.6651-1(c)(1),

Proced. & Admin. Regs.

     A taxpayer's disability or mental incapacity may be

reasonable cause for failure to file returns, United States v.

Boyle, supra at 248 n.6, but selective inability to perform tax

obligations does not excuse failure to file.   Kemmerer v.

Commissioner, T.C. Memo. 1993-394; Bear v. Commissioner, T.C.

Memo. 1992-690, affd. without published opinion 19 F.3d 26 (9th

Cir. 1994); Bloch v. Commissioner, T.C. Memo. 1992-1.
                             - 18 -


     Petitioner filed his 1990 return about 10 months late.

Petitioner testified that he had problems with Waddell's lawsuit,

his own divorce, and alcoholism.    However, he did not allege or

show that he was incapacitated or unable to file his 1990 return

by October 15, 1991, as extended.   Petitioner suggests no other

reason for filing his 1990 return late.   We sustain respondent's

determination that petitioner is liable for the addition to tax

for failure to timely file his return under section 6651(a) for

1990.

     To reflect the foregoing,


                                               Decision will be

                                     entered under Rule 155.
