                        T.C. Memo. 2005-32



                      UNITED STATES TAX COURT



             INDMAR PRODUCTS CO., INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15428-03.              Filed February 23, 2005.


     Matthew P. Cavitch and Gerald P. Arnoult, for petitioner.

     Kirk S. Chaberski, for respondent.


              MEMORANDUM FINDINGS OF FACT AND OPINION

     FOLEY, Judge:   By notice dated July 3, 2003, respondent

determined deficiencies in, and penalties related to,

petitioner’s 1998, 1999, and 2000 Federal income taxes.   After

concessions by respondent, the remaining issues for decision are

whether:   (1) The cash transfers to petitioner were loans or

capital investments; and (2) petitioner is liable for section
                                 - 2 -

66621 penalties.

                         FINDINGS OF FACT

      Indmar Products Company Inc. (petitioner), incorporated in

1971, is a marine engine manufacturer.   In 1973, petitioner was

owned equally by Richard Rowe, Sr. (Mr. Rowe), and Marty Hoffman.

In 1978, Mr. Rowe became the majority stockholder owning 51

percent of petitioner’s stock.    After Mr. Hoffman died in 1985,

Mr. Rowe and Donna Rowe (the Rowes) became the major stockholders

each owning 37.22 percent of petitioner’s stock.   Other

stockholders included Richard Rowe, Jr., and Diane Rowe (i.e.,

the Rowes’ son and daughter-in-law) and Kathy and Joseph Tidwell

(i.e., the Rowes’ daughter and son-in-law).

      From 1986 to 2000, petitioner’s business grew significantly.

Sales and costs-of-goods sold increased from $5 million and $3.9

million to $45 million and $37.7 million, respectively.    In

addition, petitioner’s working capital (i.e., current assets

minus current liabilities) increased from $471,386 to $3.8

million.   Petitioner did not declare or pay formal dividends.

      In 1987, the Rowes began transferring cash (transfers) to

petitioner with the intent to take the money out as they needed

it.   After receiving advice from numerous estate planners, the



      1
       Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
                               - 3 -

Rowes wanted to characterize the transfers as loans because the

Rowes believed that additional equity in petitioner would

increase their estate tax burden and reduce the amount of

property received by their heirs.    The transfers were unsecured,

undocumented, and petitioner agreed to pay a 10-percent return on

all transfers from 1987 through 2000.    During this 14-year

period, the prime rate fluctuated between 6 and 9.5 percent for

almost 12 years.   Petitioner made monthly payments to the Rowes

calculated at 10 percent of the transferred funds (i.e.,

reflected in the “notes payable - stockholders” account balance).

The monthly payments represented an investment return and were

not repayments of the transfers.    Petitioner’s partial

repayments, however, were sporadic, paid on demand, based on the

Rowes’ financial needs, and not subject to set or predetermined

due dates.   From 1987 to 2000, the Rowes’ transfers were not

repaid in full.

     Tennessee residents, pursuant to Tenn. Code Ann. sec. 67-2-

101 (2000), are taxed on the receipt of dividends and interest.

Promissory notes that mature in 6 months or less are, pursuant to

Tenn. Code Ann. sec. 67-2-101(1)(B)(i), exempt.    To avoid the tax

on interest and dividends, petitioner and the Rowes took the

position that the transfers were demand notes.    Petitioner,

however, reported the transfers as long-term liabilities, on its

financial statements, to avoid violating loan agreements with
                                 - 4 -

First Tennessee Bank (FTB) (i.e., petitioner’s main creditor)

requiring petitioner to maintain a certain ratio of current

assets to current liabilities.

     In 1989, petitioner’s accountant, Wesley Holmes, decided

that petitioner needed documentation to support the reporting of

the transfers as long-term liabilities.   Mr. Holmes determined

that the transfers could be reported as long-term liabilities if

the Rowes signed a waiver agreeing to forgo repayment for at

least 12 months.   From 1989 through 2000, the notes to

petitioner’s financial statements disclosed that “The

stockholders have agreed not to demand payment within the next

year”, and in 1992 and 1993, the Rowes signed written agreements

stating that they would not demand repayment of the transfers

(waivers).    Despite these disclosures and agreements, the Rowes

demanded and received seven partial repayments totaling

$1,105,169.

     Petitioner recorded in its books and records, all transfers

as “notes payable - stockholders” and reported, on its Federal

income tax returns, the monthly payments to stockholders as an

interest expense deduction.   Consistent with petitioner’s

treatment of the monthly payments, the Rowes reported (i.e., on

their individual income tax returns), these payments as interest

income.   Outstanding “notes payable - stockholders” delineated in

petitioner’s 1986 financial statements totaled $209,500 and
                                 - 5 -

reached a high of $1,779,169 in 1991.     In 1993, Richard Rowe,

Jr., and Joseph Tidwell made a transfer of $25,000 and $18,000,

respectively, but also demanded repayment of $110,000 and

$26,000, respectively, for education expenses.     In 1998, Donna

Rowe demanded repayment of $180,000 for boat repairs.     Mr. Rowe,

in 1994 and 1995, demanded repayment of $15,000 and $650,000,

respectively, to pay his taxes and purchase a home.     Mr. Rowe

also demanded repayment of $84,948, $80,000, $25,000, and $70,221

in 1997, 1998, 1999, and 2000, respectively, to pay litigation,

boat repair, and tax expenses.    The Rowes, in 1997 and 1998, made

additional transfers to petitioner of $500,000 and $300,000,

respectively.   The balance of “notes payable - stockholders” on

December 31, 2000, totaled $1,166,912.2

     In 1993, Mr. Holmes determined that a promissory note should

be executed for a portion of the previously undocumented

transfers from the Rowes.   Petitioner, on December 31, 1993,

executed a promissory note (1993 note) with Donna Rowe for

$201,400 (i.e., her outstanding balance) of the $1.5 million

total outstanding balance of the transfers.     The 1993 note was

payable on demand, was freely transferable, had no maturity date

or payment schedule, and had a stated interest rate of 10



     2
       This amount also reflects a net decrease of $214,088 that
was reported in 1992. The record, however, is not clear as to
how many transfers and/or repayments were made during that year
or which stockholders were involved in the 1992 transactions.
                                - 6 -

percent.   On November 21, 1995, petitioner executed a promissory

note (1995 note) with Mr. Rowe for $605,681 (i.e., his

outstanding balance) of the $807,081 total outstanding balance of

the transfers.    The 1995 note was payable on demand, was freely

transferable, had no maturity date or payment schedule, and had a

stated interest rate of 10 percent.

     On January 1, 1998, when the outstanding transfers totaled

$1,222,133, petitioner executed two written line of credit

agreements with the Rowes for $1,000,000 and $750,000.     The line

of credit agreements provided that the balances were payable on

demand, and the notes were freely transferable.     In addition, the

agreements provided a stated interest rate of 10 percent and had

no maturity date or payment schedule.

     Petitioner was profitable, and numerous banks sought to lend

petitioner money.   As a result, FTB worked diligently to retain

petitioner’s business, made funds immediately available upon

petitioner’s request, and was willing to lend petitioner 100

percent of the transferred amounts.     FTB, however, required

petitioner to subordinate (i.e., to FTB’s outstanding loans with

petitioner) all transfers.

     In 1993, FTB lent petitioner $1,850,000.     The loan agreement

stated “no payments shall be made by Borrower to satisfy any

* * * [stockholder] indebtedness for so long as the Loans shall

remain unpaid.”   Petitioner, however, made partial repayments to
                                 - 7 -

stockholders while FTB loans remained outstanding.     On November

21, 1995, when the prime rate was 8.5 percent, petitioner

borrowed $650,000 from FTB, at 7.5 percent, to pay Mr. Rowe.      In

1997, petitioner and FTB executed a promissory note for

$1,000,000 that was modified in 1998.     The interest rate on the

note was below the prime rate.     At the time the petition was

filed, petitioner’s principal place of business was located in

Millington, Tennessee.

                                OPINION

     Respondent contends that petitioner’s interest expense

deductions relating to payments made to the Rowes should be

disallowed because the transfers were capital investments and not

loans.     Petitioner contends that the transfers were loans.

     Taxpayers are entitled to a deduction for payments made on

bona fide indebtedness that relates to an existing,

unconditional, and legal obligation to repay.     Sec. 163(a);

Burrill v. Commissioner, 93 T.C. 643 (1989).     Petitioner bears

the burden of proving that the transfers are debt and not

equity.3    Rule 142(a); Smith v. Commissioner, 370 F.2d 178, 180

(6th Cir. 1966), affg. T.C. Memo. 1964-278.

     Transfers between related parties are examined with special

scrutiny when taxpayers contend that such transfers are loans.


     3
       Sec. 7491(a) is inapplicable because petitioner does not
meet the net worth requirements of sec. 7430(c)(4)(A)(ii), which
are cross-referenced in sec. 7491(a)(2)(C).
                                 - 8 -

Roth Steel Tube Co. v. Commissioner, 800 F.2d 625, 630 (6th Cir.

1986), affg. T.C. Memo. 1985-58.     In determining the economic

reality of a related party transfer, “‘the ultimate issue is

* * * whether the transaction would have taken the same form had

it been between the corporation and an outside lender’”.          Fed.

Express Corp. v. United States, 645 F. Supp. 1281, 1290 (W.D.

Tenn. 1986) (quoting Scriptomatic, Inc. v. United States, 555

F.2d 364 (3d Cir. 1977)).   The more a transfer appears to result

from an arm’s-length transaction, the more likely the transfer

will be considered debt.    Bayer Corp. v. Mascotech, Inc., 269

F.3d 726, 750 (6th Cir. 2001).

     In distinguishing between debt and equity, courts also

analyze whether the contemporaneous facts establish an

unconditional obligation to repay.       Roth Steel Tube Co. v.

Commissioner, supra at 630; Smith v. Commissioner, supra at 180;

see Burrill v. Commissioner, supra at 669.       In Roth Steel, the

Court of Appeals for the Sixth Circuit used an 11-factor test to

determine whether the transfer was debt or equity.4      No factor is


     4
       The 11 factors are: (1) Identity of interest between
creditor and stockholder, (2) adequacy or inadequacy of
capitalization, (3) source of payments, (4) name given
instruments evidencing indebtedness, (5) presence or absence of
fixed maturity date and schedule of payments, (6) presence or
absence of a fixed rate of interest and interest payments, (7)
presence or absence of security, (8) inability to obtain outside
financing, (9) subordination of transfers, (10) presence or
absence of a sinking fund, and (11) extent to which the transfers
were used to acquire capital assets. Roth Steel Tube Co. v.
                                                   (continued...)
                               - 9 -

controlling or decisive by itself and the particular

circumstances of each case must be considered by the court.      Roth

Steel Tube Co. v. Commissioner, supra at 630.    “These factors are

merely tools to be used in evaluating whether the transaction as

a whole was effected with a genuine intention to create a debt,

with a reasonable expectation of repayment, and within the

economic realities of a debtor-creditor relationship.”    Recklitis

v. Commissioner, 91 T.C. 874, 905 (1988).

I.   The Rowes’ Objectives for Characterizing the Cash Transfers
     as Debt

     The Rowes’ characterized the cash transfers as debt because

they wanted to receive a 10-percent return on their investment

and minimize estate taxes.   Mr. Rowe testified that they received

advice from numerous estate planners and decided to characterize

the transfers as loans because “we felt additional equity would

only hurt the family at our death.”    For nearly 12 of the 14

years, from 1987 to 2000, the 10-percent rate charged by the

Rowes was above the market and prime interest rates.    For

example, in 1998 when the prime rate was 8.5 percent, petitioner

executed loan agreements with the Rowes and FTB at fixed rates of

10 and 7.5 percent, respectively.   Mr. Rowe testified,

unconvincingly, that the higher rate charged by the Rowes



     4
      (...continued)
Commissioner, 800 F.2d 625, 630-632 (6th Cir. 1986), affg. T.C.
Memo. 1985-58.
                               - 10 -

balanced out over time because the prime rate fluctuated above

and below 10 percent.   The prime rate, however, exceeded 10

percent only from November 28, 1988, to January 8, 1990.   Indeed,

the prevailing interest rate was irrelevant.   The Rowes simply

wanted to receive a 10-percent return.

II.   Petitioner and the Rowes Manipulated Facts and Violated
      Legal Agreements

      To avoid being subject to the Tennessee tax on interest and

dividends, petitioner and the Rowes took the position that the

transfers were demand notes.   Petitioner, however, reported the

transfers as long-term liabilities on its financial statements.

Mr. Holmes readily admitted that the transfers were reported

incorrectly.   In addition, petitioner and Mr. Holmes knowingly

mischaracterized the transfers as long-term liabilities to comply

with FTB’s loan agreements.

      To justify the reporting of the transfers as long-term

liabilities, petitioner and the Rowes executed annual waivers.

Mr. Rowe, however, testified that he did not consider the waivers

to be legally binding and that the waivers would not prevent

petitioner from repaying him on demand.   While the waivers were

disclosed in the financial statements from 1989 to 2000,

petitioner paid the Rowes on demand.

      Mr. Rowe also testified that the informal undocumented

agreements with petitioner were consistent with a history of

“handshake deals” he had with petitioner and other business
                              - 11 -

associates.   His testimony, however, was contradictory,

inconsistent, and unconvincing.   For example, Mr. Rowe testified

that either “a handshake” or “a signature” was sufficient to bind

him to an agreement.   Yet, he readily failed to honor his

“agreements” not to demand repayment.   In addition, despite the

FTB loan restrictions on repayments to stockholders, when the

Rowes needed cash for personal needs, petitioner paid them on

demand.   In essence, the Rowes simply wanted to receive a 10-

percent return on, and ready access to, the transferred funds.

As a result, petitioner, along with the Rowes, manipulated facts

to attempt to make the transfers appear as debt and avoid certain

legal consequences.

III. The Transactions Were Not Arm’s Length

     The transfers between petitioner and the Rowes were not

arm’s-length transactions.   First, because the Rowes wanted a 10-

percent return, the interest rate paid by petitioner was above

the market and prime rates for almost 12 years.   Second, the

Rowes began transferring funds to petitioner in 1987 but did not

begin reducing the “handshake deals” to a writing until December

31, 1993, and the outstanding balance was not fully documented

until November 21, 1995.   In 1997, the Rowes made additional

transfers, but they were not evidenced by a writing until 1998.

Third, petitioner and the Rowes executed waivers that were

violated, and, at their convenience, considered nonbinding.
                               - 12 -

Thus, the transactions between petitioner and the Rowes did not

take the same form as transactions between unrelated parties.

IV.   The Roth Steel Test

      In addition to the transfers not being arm’s-length

transactions, the 11-factor test set forth in Roth Steel Tube Co.

v. Commissioner, 800 F.2d 625 (6th Cir. 1986), establishes that

the transfers were equity.    First, petitioner did not pay any

formal dividends.   Jaques v. Commissioner, 935 F.2d 104, 106 (6th

Cir. 1991), affg. T.C. Memo. 1989-673.       Second, pursuant to 12

consecutive years of waivers, there was no fixed maturity date or

fixed obligation to repay.    Roth Steel Tube Co. v. Commissioner,

supra at 631; Jaques v. Commissioner, supra at 108 (stating that

a taxpayer’s failing to repay debt within a reasonable time and

making “sporadic” principal payments are factors that weigh in

favor of equity).   Third, Mr. Rowe testified that petitioner was

expected to make a profit and that repayment “has to come from

corporate profits or else the company couldn’t pay for it.”         Roth

Steel Tube Co. v. Commissioner, supra at 631 (stating “An

expectation of repayment solely from corporate earnings is not

indicative of bona fide debt regardless of its reasonableness.”

(citing Lane v. United States, 742 F.2d 1311, 1314 (11th Cir.

1984))).   Fourth, the transfers were unsecured.      Roth Steel Tube

Co. v. Commissioner, supra at 631.      Finally, petitioner never

established a sinking fund.    Id. at 632.     These factors certainly
                               - 13 -

outweigh the factors in favor of characterizing the transfers as

debt (e.g., petitioner reported the payments on its Federal

income tax returns as interest expense, external financing was

available, petitioner was adequately capitalized, the transfers

were not subordinated to all creditors, and the Rowes did not

make the transfers in proportion to their respective equity

holdings).    Moreover, petitioner failed to establish that, at the

time the transfers were made, it had the requisite unconditional

and legal obligation to repay the Rowes (e.g., the transfers were

not documented).    Thus, we conclude that the Rowes’ transfers

were equity.    Accordingly, petitioner is not entitled to an

interest expense deduction relating to the years in issue.

     Respondent also determined that petitioner is liable for a

section 6662(a) accuracy-related penalty.    The penalty applies to

the portion of petitioner's underpayment that is attributable to

a substantial understatement of income tax.    Sec. 6662(b)(2).

Respondent established that petitioner understated its income tax

liability, and thus, respondent has met his burden of production,

pursuant to section 7491(c).    Petitioner, however, failed to

address this issue on brief and did not present any credible

evidence to establish that it acted in good faith or that there

was reasonable cause for claiming the interest expense

deductions.    Accordingly, the accuracy-related penalty is

applicable to the underpayment attributable to the stockholder
                             - 14 -

payments.

     Contentions we have not addressed are irrelevant, moot, or

meritless.

     To reflect the foregoing,



                                         Decision will be entered

                                  under Rule 155.
