                        T.C. Memo. 1998-104



                      UNITED STATES TAX COURT



         ABDUL HAFIZ AND RAWNAQ A. HAFIZ, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15079-96.                     Filed March 16, 1998.



     Lawrence H. Richards, for petitioners.

     Katherine Lee Wambsgans, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:   Respondent determined deficiencies in

petitioners' income taxes of $52,837 and $73,542 for the taxable

years 1989 and 1990, respectively.   The sole issue remaining for

our consideration is whether petitioners, as S corporation

shareholders, may increase their bases in the S corporation by
                               - 2 -


the amount of debt for which they and the corporation were the

primary obligors.

                         FINDINGS OF FACT1

     Petitioners Abdul and Rawnaq Hafiz are husband and wife and

timely filed joint Federal income tax returns for the years 1989

and 1990.   Petitioners resided in North Jackson, Ohio, at the

time they filed their petition in this case.

     In the late 1970's, petitioner Abdul Hafiz (Mr. Hafiz)

entered into a partnership to invest in the motel business.     The

partnership owned and operated a Days Inn in Monroe, Ohio.    In

1984, the partnership began experiencing severe financial

difficulties.   Mr. Hafiz decided to purchase the motel from the

partnership in the hopes of turning it into a profitable

enterprise.

     In 1985, Mr. Hafiz decided to form Family Motels, Inc.

(Family Motels), a corporation that elected to be treated as a

"small business corporation" under subchapter S.    Mr. Hafiz was a

90-percent shareholder of Family Motels, and his family members

held the remaining shares.   Family Motels was organized to

acquire and manage motels.

     At the time of incorporation, it was necessary to borrow

funds to purchase the Days Inn in Monroe.    Mr. Hafiz met with


     1
       The stipulation of facts and the attached exhibits are
incorporated by this reference.
                                 - 3 -


Bank One of Eastern Ohio (Bank One) on behalf of himself and

Family Motels to discuss a possible loan.     After reviewing Mr.

Hafiz's financial statements, Bank One agreed to lend Mr. Hafiz

and Family Motels $1.6 million toward the purchase price of the

motel.    The loan agreement required that the proceeds of the loan

be used to purchase the motel.    Mr. Hafiz was required to pledge

all of his personal real estate holdings, bank accounts,

certificates of deposit, and his pension plan as security for the

loan.    The loan was also secured by a mortgage on the motel.

Family Motels, Abdul Hafiz, M.D., Inc.,2 and petitioners were the

primary obligors under the loan.

     In 1988, Mr. Hafiz and Family Motels applied for a second

loan with Bank One for the purchase of a Days Inn in Seymour,

Indiana.    Bank One agreed to lend Mr. Hafiz and Family Motels

$1,550,000 for the purchase of the motel.     Once again, Mr. Hafiz

was required to pledge all of his assets as security for the loan

and mortgage the motel to the bank.      The commitment letter stated

that the source of repayment would come from the operating income

of the motel.    Petitioners, Family Motels, and Abdul Hafiz, M.D.,

Inc., were the primary obligors under the loan.

     Although Mr. Hafiz received promissory notes from Family

Motels equal to the amount of the loans at issue, the


     2
       Abdul Hafiz, M.D., Inc., was the professional corporation
for Mr. Hafiz's medical practice.
                               - 4 -


corporation's accounting records treated the loans as loans from

the bank, not as loans from petitioners-shareholders.    In

addition, Family Motels made the loan payments to the bank.

Neither petitioners nor Family Motels reported payments on the

loans made by Family Motels as constructive dividends, and Family

Motels deducted the interest paid on the loans.

     From the time of incorporation, Family Motels suffered

significant losses.   Petitioners increased their adjusted bases

in the indebtedness of Family Motels by the full amount of the

loans from Bank One and claimed deductions for the losses of

Family Motels under section 1366(a)(1)(B)3 in the amounts of

$296,236 and $432,007 for the taxable years 1989 and 1990,

respectively.   Respondent determined that petitioners' bases in

the indebtedness of Family Motels did not include the loans from

Bank One and disallowed the losses claimed in 1989 and 1990 that

exceeded petitioners' adjusted bases in the stock and

indebtedness of Family Motels prior to the increase from the

loans.

                              OPINION

     Under section 1366, S corporation shareholders may deduct

their pro rata share of losses and deductions of the S


     3
       Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years under
consideration, and all Rule references are to this Court's Rules
of Practice and Procedure.
                                 - 5 -


corporation.     The deductions, however, are limited to the sum of

the adjusted basis of the shareholders' stock in the corporation,

sec. 1366(d)(1)(A), and the adjusted basis of any indebtedness of

the corporation to the shareholders, sec. 1366(d)(1)(B).

     Petitioners contend that they were primary obligors under

the loans and that Bank One looked primarily to Mr. Hafiz and to

his personal assets for repayment.       Petitioners argue that the

loans at issue should be viewed as loans to petitioners, followed

by a loan from petitioners to Family Motels for the same amount.

Petitioners assert that they are entitled to increase their bases

in the indebtedness of the corporation to them by the amount of

the loans.     In the alternative, petitioners argue that they

should be entitled to increase their bases in the indebtedness of

Family Motels by a portion4 of the loans.      Respondent contends

that because petitioners did not make any payments under the

loans, petitioners are not entitled to increase their bases.

     To increase the basis in the indebtedness of an S

corporation, there must be an economic outlay on the part of the

shareholder.     Estate of Leavitt v. Commissioner, 875 F.2d 420,

422 (4th Cir. 1989), affg. 90 T.C. 206 (1988); Brown v.

Commissioner, 706 F.2d 755, 756 (6th Cir. 1983), affg. T.C. Memo.


     4
       Petitioners argue that because Mr. Hafiz, Mrs. Hafiz,
Family Motels, and Abdul Hafiz, M.D., Inc., were the obligors
under the loans, they should be entitled to increase their bases
in their stock by one-half of the amount of the loans.
                                   - 6 -


1981-608.5      The economic outlay required under section

1366(d)(1)(B) must leave "the [taxpayers] poorer in a material

sense."       Perry v. Commissioner, 54 T.C. 1293, 1296 (1970), affd.

per order (8th Cir. 1971) (quoting Horne v. Commissioner, 5 T.C.

250, 254 (1945)).      Although a bona fide loan from a shareholder

to an S corporation will increase the shareholder's basis, the

shareholder must make an actual economic outlay and directly

incur the indebtedness.       Underwood v. Commissioner, 63 T.C. 468,

476 (1975), affd. 535 F.2d 309 (5th Cir. 1976).      As was noted by

this Court in Raynor v. Commissioner, 50 T.C. 762, 770-771

(1968):

       No form of indirect borrowing, be it guaranty, surety,
       accommodation, comaking or otherwise, gives rise to
       indebtedness from the corporation to the shareholders
       until and unless the shareholders pay part or all of
       the obligation. Prior to that crucial act, "liability"
       may exist, but not debt to the shareholders. * * *

The shareholders must make actual disbursements on the

indebtedness before they can augment their bases for the purpose

of deducting losses.       Estate of Leavitt v. Commissioner, supra at

422.       Since petitioners have not made actual disbursements on the

loans, they are not entitled to increase their bases.


       5
       Most of the cases interpreting "indebtedness of the S
corporation to the shareholder" apply to former sec. 1374(c)(2).
That section was repealed by the Subchapter S Revision Act of
1982, Pub. L. 97-354, sec. 2, 96 Stat. 1669, 1677-1683, effective
for tax years beginning after Dec. 31, 1982. There are no
differences between former sec. 1374(c)(2)and the current sec.
1366(d)(1)(B) that affect this analysis.
                                - 7 -


     Petitioners argue that we should ignore the form of the

loans and rely on the economic substance in deciding whether the

loans were actually made to petitioners.    We find that the form

and substance of the transaction was a loan from the bank to

Family Motels.    The proceeds of the loan were to be used to

purchase the motels on behalf of the corporation.    Petitioners

submitted no evidence that they were free to dispose of the

proceeds of the loans as they wished.    Nor were the payments on

the loans reported as constructive dividends in the corporation's

income tax returns or on petitioners' income tax returns during

the years in issue.    Family Motels made all of the loan payments

to the bank and deducted the interest paid on the loans.    At

trial, Mr. Hafiz stated that he occasionally made payments on the

loans at issue.    This, however, is contrary to the stipulation of

facts.   A party is not permitted to contradict a stipulation in

whole or in part, except in the interest of justice.    Rule 91(e);

Stamos v. Commissioner, 87 T.C. 1451, 1454 (1986).     Petitioners

have offered no evidence other than Mr. Hafiz's assertions at

trial that any payments were made by Mr. Hafiz.    We deem the

prior stipulation to be binding.    Petitioners are not entitled to

increase their bases in their stock by the amount of the loans.

     Nor can petitioners increase their adjusted bases by a

portion of the loans.    Absent an actual disbursement on the

indebtedness, shareholders cannot augment their bases in
                               - 8 -


indebtedness for the purpose of deducting losses.        Brown v.

Commissioner, supra at 757.   Accordingly, respondent's

determination is sustained.


                                            Decision will be entered

                                       under Rule 155.
