                  T.C. Memo. 2009-76



                UNITED STATES TAX COURT



    MARVIN S. AND THELMA S. KERZNER, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 21336-06.               Filed April 6, 2009.



     Using proceeds of loans from a wholly owned
partnership, Ps made annual loans of identical amounts to a
wholly owned S corporation, which in turn paid equivalent
amounts of rent back to the partnership. In certain years
Ps also lent the S corporation additional amounts. R
disallowed the S corporation’s passthrough losses to Ps for
the 2001 tax year, asserting that Ps lacked a sufficient
basis under sec. 1366(d)(1), I.R.C.

     Held: Ps did not    acquire a basis in indebtedness of
the S corporation from   the annual loans since the
transaction involved a   circular flow of funds and,
therefore, Ps had made   no economic outlay.


H. Peter Olsen and Frederick P. McClure, for petitioners.

Frank W. Louis, for respondent.
                                  - 2 -

                           MEMORANDUM OPINION


       NIMS, Judge:    Respondent determined deficiencies in

petitioners’ Federal income tax as follows:

                Year                            Deficiency

                1996                             $20,440
                1997                               9,804
                1998                                 593
                2001                              20,534


       The issue for decision is whether petitioners made an

economic outlay on yearly loans to their S corporation, giving

them a sufficient basis in indebtedness under section 1366(d)(1)

to claim the S corporation’s losses in 2001 and carry back the

resulting excess net operating loss to the 1996 and 1997 tax

years.

       Unless otherwise indicated, all Rule references are to the

Tax Court Rules of Practice and Procedure, and all section

references are to the Internal Revenue Code in effect for the

years in issue.

                               Background

       This case was submitted fully stipulated pursuant to Rule

122.    The stipulations of the parties, with accompanying

exhibits, are incorporated herein by this reference.

       Petitioners filed a timely 2001 Form 1040, U.S. Individual

Income Tax Return, and a Form 1045, Application for Tentative

Refund, in which they claimed a passthrough loss from Highland
                                 - 3 -

Court, Inc. (HCI), for the year and carried the resulting excess

net operating loss back to the 1996 and 1997 tax years.

Respondent sent petitioners notices of deficiency for the 1996,

1997, 1998, and 2001 tax years, and petitioners filed a petition

in response thereto.    Petitioners resided in Rhode Island when

they filed their petition.

     In 1986 petitioners formed the Highland Court Associates

partnership (HCA) and HCI, an S corporation within the meaning of

section 1361(a).     Since that time, each petitioner has continued

to be a 50-percent partner and a 50-percent shareholder,

respectively, in the two entities.

     HCA borrowed money from a third-party lender to acquire and

construct real property.    The loan (HUD loan) was a nonrecourse

loan which fell under section 232 of the National Housing Act.

HCA, with Marvin Kerzner (Dr. Kerzner) signing as general

partner, eventually refinanced the HUD loan with Reilly Mortgage

Group, Inc. (Reilly) on August 28, 1997, in the amount of

$4,335,000.   Reilly was given a security interest in certain

property of HCA, which included the notes from petitioners

referred to below.

     The parties have stipulated that Internal Revenue Service

Tech. Adv. Mem. 200619021 (May 12, 2006)(TAM), relates to this

case and that the statement of facts in the TAM “[is] herewith
                                - 4 -

incorporated by reference as though separately set forth in this

stipulation of facts.”    Consequently, we also rely herein to a

substantial extent on that statement of facts.

       For each year from 1986 to 2001 HCA lent money to

petitioners, petitioners lent money to HCI, and HCI paid rent to

HCA.    Under the terms of the HUD loan no portion of that loan’s

proceeds could be used in the loan arrangements among

petitioners, HCA, and HCI.    Loans from HCA to petitioners were

permitted only if the third-party lender approved, if the

proceeds were made from HCA’s net profits (after debt service to

HUD), and if the proceeds were used to fund HCA’s activities.

For each loan between HCA and petitioners and between petitioners

and HCI, notes were drafted near the end of the calendar year and

within a short time of each other.      Each note included the total

outstanding loan balance and, therefore, revised and superseded

the loan notes issued in the prior year.      Each note required no

principal payments until the end of the following year.     Most of

these notes stated an interest rate, but the notes petitioners

issued to HCA from 1996 through 1999 did not.

       Proceeds of the loans from HCA to petitioners were deposited

into one of several personal bank accounts held by Dr. Kerzner

individually or jointly with his wife.     The loans were booked as

“Other Current Assets” that were “Due from Partners” on HCA’s

balance sheet.    As a result of the flowthrough aspects of the
                               - 5 -

partnership, petitioners reported the interest income yearly on

their Schedules K-1, Partner’s Share of Income, Credits,

Deductions, etc., and B, Interest and Ordinary Dividends.   They

deducted a corresponding investment interest expense on their

Schedule A, Itemized Deductions.

     Funds for the loans from petitioners to HCI (yearly loans)

were issued out of one of petitioners’ personal bank accounts and

deposited into HCI’s bank accounts.    These loans are reflected on

HCI’s balance sheet as “Loans from Shareholder”.   HCI did not

deduct accrued interest expense for tax purposes, and petitioners

did not report accrued interest income as part of their gross

income.

     Petitioners made additional loans to HCI in 2000 and 2001

(additional loans) of $70,551 and $50,000, respectively.

     Aside from a $14,233 repayment of principal during the 1993

tax year by HCI to petitioners, no payments of principal or

interest were ever made on any of these notes.   After the 1999

year, pursuant to requirements imposed by HUD, the loans were

combined into a single surplus cash note issued by HCI to

petitioners.   The surplus cash note stated an interest rate.

     Regardless of which specific accounts were involved,

petitioners used one of their personal accounts to deposit all
                                 - 6 -

loan proceeds from HCA and to write all checks to HCI.    In every

case, both the receiving and lending of funds by petitioners

occurred within a short time of each other.

     In 2001, specifically, the flow of activity among HCA,

petitioners, and HCI was as follows:

     •   HCA issued petitioners a check in the amount of $80,000

         on December 24, 2001.    The check was deposited into

         their personal checking account on December 26, 2001.

     •   Petitioners issued to HCI an $80,000 check from their

         personal rental checking account on December 24, 2001.

         The check was deposited into the HCI business checking

         account on the same day.

     •   Petitioners wrote an additional $50,000 check to HCI out

         of their personal checking account on December 27, 2001.

         The check was deposited into the HCI checking account on

         the same day.

     Petitioners also wrote off $453,098 of accrued interest on

loans to HCI in 2001 by making an entry on HCI’s books to

reclassify the amount from accrued interest payable to additional

paid-in capital.   The entry was made to reduce the accrued

interest to coincide with the surplus cash note balance.    The

reclassification entry reflected Dr. Kerzner’s assent to HUD’s

request to recalculate accrued interest on the basis of net

advances rather than gross amounts outstanding.
                               - 7 -

     For the 1986 through 2001 tax years petitioners claimed

passthrough losses from HCI.   They dispute respondent’s

determination that 2001 losses from HCI should be suspended

because of a lack of bases in stock and indebtedness, which

caused an alleged $130,905 increase in taxable income for 2001.

They also dispute the disallowance of a previously allowed

carryback of the net operating loss to petitioners’ 1996 and 1997

years and alleged increases in taxable income for 1996 and 1997

in the respective amounts of $105,255 and $15,354.

     Petitioners have conceded all other adjustments proposed in

the notices of deficiency, other than consequential computational

adjustments.

                            Discussion

     In determining tax liability for the year in which an S

corporation’s taxable year ends, section 1366(a) requires

shareholders to take into account their pro rata shares of:    (1)

The corporation’s income, losses, deductions, and credits whose

separate treatment could affect the tax liability of any

shareholder and (2) its non-separately computed income or loss.

The aggregate amount of losses and deductions for any taxable

year cannot exceed the sum of the shareholder’s adjusted bases in

the corporation’s stock and any indebtedness of the S corporation

to the shareholder.   Sec. 1366(d)(1).
                               - 8 -

     In order to acquire basis in indebtedness of an S

corporation, the caselaw has required that:      (1) The indebtedness

run directly from the S corporation to the shareholder and (2)

the shareholder make an actual economic outlay that renders him

poorer in a material sense.   Underwood v. Commissioner, 63 T.C.

468 (1975), affd. 535 F.2d 309 (5th Cir. 1976); Perry v.

Commissioner, 54 T.C. 1293, 1296 (1970), affd. per order 27 AFTR

2d 71-1464, 71-2 USTC par. 9502 (8th Cir. 1971); Kaplan v.

Commissioner, T.C. Memo. 2005-218.

     There is no question that an indebtedness runs directly from

the S corporation, HCI, to the shareholders, petitioners.

Petitioners contend that this renders the economic outlay

doctrine inapplicable.   But we have held that

        In order to increase basis in an S corporation, the
     shareholder must make an actual economic outlay; to
     satisfy this requirement, even in circumstances where
     the taxpayer purports to have made a direct loan to the
     S corporation, the taxpayer must show that the claimed
     increase in basis was based on “some transaction which
     when fully consummated left the taxpayer poorer in a
     material sense.” * * * [Kaplan v. Commissioner,
     supra, and cases cited therein; citations and some
     quotation marks omitted.]

     The issue is thus whether petitioners made an economic

outlay on the yearly loans to HCI.

     We have previously held that transactions involving a brief,

circular flow of funds (beginning and ending with the original

lender) designed solely to generate bases in an S corporation

have no economic substance and therefore do not evidence the
                                - 9 -

required economic outlay.    Oren v. Commissioner, T.C. Memo. 2002-

172, affd. 357 F.3d 854 (8th Cir. 2004).   In Oren, the taxpayers

engaged in a circular loan transaction in an attempt to claim

depreciation deductions otherwise in excess of bases in their S

corporations.   Starting from the taxpayers’ other S corporation,

loans of identical or almost identical amounts of money circled

around to the taxpayers, to the S corporations with the

depreciation deductions, and then back to the first S

corporation.    In holding that no economic outlay had been made,

we found that the economic positions of the parties had not

changed and that the disbursements of loan proceeds were the

equivalent of offsetting bookkeeping entries.   We noted that the

cashflow on the loan repayments confirmed the transactions’ lack

of economic substance because they too followed a circular route.

The Court of Appeals for the Eighth Circuit relied on similar

reasoning to affirm our decision.

     We have reached this same conclusion even where a loan was

not used at every step of the circular transaction.     Kaplan v.

Commissioner, supra.    In Kaplan, the taxpayer lent proceeds of a

bank loan to his S corporation.   That corporation paid the

proceeds over to another S corporation owned by the taxpayer,

which then lent the money back to the taxpayer.   Since the first

S corporation had an account payable due to the second, the

taxpayer argued that the transfer between the S corporations was
                              - 10 -

a repayment of debt and the entire transaction was therefore not

a circular loan.   Because this transfer was not a loan, the debts

of the first S corporation and the taxpayer technically continued

to exist, unlike those in Oren v. Commissioner, supra, since

there was no opposing cycle of loan repayments to automatically

extinguish those debts.

     The taxpayer argued that he made an economic outlay because

he bore the risk that the first S corporation would not be able

to repay him.   Nevertheless, we found an inherent lack of

substance in the loans and held that the taxpayer made no

economic outlay because the transactions’ structure rendered any

purported risk illusory.   Neither of the wholly owned S

corporations would ever act adversely to the taxpayer’s

interests, and even if they did, his bank debt was secured by the

second S corporation’s bank account into which the funds were

deposited.   That meant there was no significant risk that the

bank would ever enforce payment against him in the event of a

default.   Thus, there was no real danger that he would have ever

had to contribute his own money to repay the bank debt.    The

loans’ lack of substance was confirmed when the taxpayer later

merged the S corporations, causing the debts to and from the

taxpayer to cancel out.

     In the case before us there is the same circular flow of

cash beginning and ending with HCA.    Each year, HCA lent money to
                                - 11 -

petitioners.   Petitioners then lent the proceeds to HCI.     To

complete the cycle, HCI paid rent to HCA.    Viewed in its

entirety, the transaction lacked economic substance since the

money wound up right where it started.    The fact that purely

paper debts to two parties (HCA and petitioners) were

accumulating is not enough to give the transaction substance.

See Kaplan v. Commissioner, supra.

     Petitioners made no economic outlay because they were merely

a conduit through which the money flowed and there was no real

expectation that they would repay HCA.    Like the taxpayer in

Kaplan v. Commissioner, supra, petitioners exercised complete

control over both HCA and HCI, meaning neither would act in a

manner adverse to petitioners’ interests.    Furthermore, there was

no significant risk that petitioners would themselves ever have

to repay any portion of the HUD loan.    Petitioners were never

primarily liable on the HUD loan.    The only circumstance in which

HUD would have been able to collect from petitioners would have

been in the event of HCA’s bankruptcy.    This was a highly

improbable scenario, as the conditions imposed by the HUD loan on

HCA’s ability to lend money to petitioners practically ensured

that HCA could do so only when it was profitable.    The fact that

only one repayment was ever made in 16 years further indicates

the loans’ lack of substance.
                              - 12 -

     Petitioners cite several cases as examples of the Court’s

having purportedly found an actual economic outlay despite a

circular flow of funds.   However, none of these cases actually

dealt with that fact pattern; they involved loans made by a

controlled entity directly to an S corporation also owned by the

taxpayer.   Ruckriegel v. Commissioner, T.C. Memo. 2006-78; Yates

v. Commissioner, T.C. Memo. 2001-280; Culnen v. Commissioner,

T.C. Memo. 2000-139, revd. and remanded on another issue 28 Fed.

Appx. 116 (3d Cir. 2002).   Even though in each case the money

never actually passed through the taxpayer’s hands, we treated

the transaction as a back-to-back loan involving the taxpayer

because the controlled entity had acted as the taxpayer’s

incorporated pocketbook, routinely paying off taxpayer’s expenses

on his behalf.1   The Court held that each taxpayer had made an

economic outlay despite the fact that the money came from a

related lender (i.e., the controlled entity).   In approving the

back-to-back loan structure, the Court in Ruckriegel specifically

distinguished the facts in that case from the circular loan

transaction scenario found in Oren v. Commissioner, T.C. Memo.

2002-172, and noted that the transfers were made with the valid


     1
      In Ruckriegel v. Commissioner, T.C. Memo. 2006-78, only the
wire transfers passing through the taxpayers’ hands on the way
from their partnership to their S corporation created an
accession to their basis in the latter. No basis step-up was
allowed for the direct interentity transfers as to which the
paper trail was often out of sync with the borrowing and lending
it purported to document.
                               - 13 -

purpose of providing the S corporation with working capital.

Thus, the Court concluded that assuming such a valid purpose

exists, taxpayers are generally free to arrange the transaction

in a tax-minimizing fashion.     Ruckriegel v. Commissioner, supra.

     Moreover, the taxpayers in the Ruckriegel, Yates, and Culnen

cases acted in a manner consistent with treatment of the

transactions as back-to-back loans, recording the transaction as

such on the parties’ books and actually making repayments in

accordance with the stated terms of the loans.

     In the case before us, there is no back-to-back loan

situation.   Instead, there is a circular flow of funds.   Thus,

the cases petitioners cite offer them no dispositive support.

Furthermore, even if we did not find the transaction to be

circular, the transfers between petitioners and HCI were not

truly loans, with petitioners reporting no interest income and

HCI claiming no interest deductions.    With the exception of HCI’s

single repayment of principal in 1993, none of the parties ever

made any payments on the loans.

     Petitioners also cite Gilday v. Commissioner, T.C. Memo.

1982-242, as a purportedly circular transaction case yet giving

rise to basis in indebtedness.    Gilday also discussed the

treatment of a direct loan to a controlled S corporation as a

back-to-back loan involving the shareholder but provides even

weaker support for petitioners’ position in that the lender there
                                - 14 -

was a bank.    When funds come from an unrelated third party, the

arm’s-length transaction tends to ensure that repayment will be

enforced.     Miller v. Commissioner, T.C. Memo. 2006-125.

     Here, the loan is from a related party, HCA.      The fact that

the funds are coming from a related lender does not necessarily

invalidate the transaction as long as other factors clearly

establish the economic validity of the transaction.       Bhatia v.

Commissioner, T.C. Memo. 1996-429.       However, we are unpersuaded

that petitioners would ever have to repay the loans from HCA.

     For these reasons, we hold that petitioners did not make an

economic outlay on the yearly loans and did not acquire basis in

indebtedness in those amounts.

     The parties stipulated that

     Only the following adjustments are in dispute:

        A. The disallowance of net operating losses
        carried back from 2001 * * * previously allowed
        with respect to petitioners’ 1996 and 1997
        years, resulting in increases in taxable income
        for 1996 and 1997 in the respective amounts of
        $105,255.00 and $15,354.00.

        B. The determination that losses from Highland
        Court, Inc. should be suspended due to a lack of
        basis in stock and indebtedness, resulting in an
        increase in taxable income for 2001 in the
        amount of $130,905.

     All other adjustments proposed in the statutory notices
     of deficiency on which this case is based, other than
     consequential computational adjustments, are conceded
     by the petitioners.
                             - 15 -

     Notwithstanding the above stipulation, respondent asserts

that a second issue to be decided is whether petitioners’ bases

in stock and indebtedness in HCI in an open year must be computed

using previously deducted losses in excess of their basis in

stock and indebtedness in years that are now closed.   This issue

was also discussed in the TAM.   However, since petitioners do not

challenge respondent’s position on this issue, either in their

petition or on brief, the issue is deemed moot.

     We have considered all of the contentions and arguments of

the parties that are not discussed herein, and we hold them to be

without merit and/or irrelevant.

     To reflect the foregoing,


                                         Decision will be entered

                                    under Rule 155.
