                       T.C. Memo. 2005-204



                     UNITED STATES TAX COURT



         FLEMING G. AND SHERRY H. BROOKS, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent

ESTATE OF FLEMING S. BROOKS, DECEASED, WILLIAM H. CARR AND MERLE
    R. BROOKS, PERSONAL REPRESENTATIVES AND MERLE R. BROOKS,
   Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 8981-03, 8983-03.1     Filed August 25, 2005.



     Jo Karen Parr, Alan E. Rothfeder, and Carla C. Gilmore, for

petitioners.

     Marshall R. Jones and Robert W. West III, for respondent.




     1
      These cases are consolidated for purposes of briefing and
opinion (hereafter collectively the instant case).
                                   - 2 -

                          MEMORANDUM OPINION


     WELLS, Judge:   Respondent determined deficiencies in Federal

income taxes for petitioners Fleming G. Brooks and Sherry H.

Brooks in the case at docket No. 8981-03 as follows:

                                           Addition to tax
          Year       Deficiency              Sec. 6662(a)

          1999          $207,552               $997.60
          2000           190,105              1,027.60

Respondent determined deficiencies in Federal income taxes and

additions to tax for the Estate of Fleming S. Brooks and Merle R.

Brooks in the case at docket No. 8983-03 as follows:

                 Year              Deficiency

                 1999               $157,207
                 2000                163,910

     After concessions, the issue to be decided is whether the

advances of open account debt by petitioners to their closely

held S corporation in 1999 and 2000 provided petitioners with

basis to offset repayments of open account debt made by the

company in 1999 and 2000, prior to each respective advance.2




     2
      All section references are to the Internal Revenue Code, as
amended, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
                                 - 3 -

                          Background

     The parties submitted the instant case fully stipulated,

without trial, pursuant to Rule 122.     The parties’ stipulations

of fact are incorporated herein by reference and are found as

facts in the instant case.

     Petitioners Fleming G. Brooks and Sherry H. Brooks are

husband and wife.   At the time of filing the petition, they

resided in Samson, Alabama.   During the years in issue, Fleming

S. Brooks and Merle R. Brooks were husband and wife.    Fleming S.

Brooks died on March 30, 2001.    At the time of filing the

petition, Merle R. Brooks resided in Samson, Alabama.    Fleming G.

Brooks and Fleming S. Brooks (Messrs. Brooks) and their

respective spouses were calendar year taxpayers.

     At all relevant times, Fleming S. Brooks owned 51 percent of

the stock of Brooks AG Company, Inc., (the company), and Fleming

G. Brooks owned 49 percent.   The company was an S corporation

with a calendar year tax year, and Messrs. Brooks each had a zero

basis in their stock in the company during all relevant times.

     Before and during the years in issue, Messrs. Brooks

advanced money to the company on open account on three occasions.

The open account transactions and related computations of Messrs.

Brooks are described in detail in the Appendix to this opinion.

The first such advance occurred during 1997, when Messrs. Brooks

each advanced $500,000 to the company on open account (referred
                                - 4 -

to collectively as the $1 million advance).   The second advance

occurred on December 31, 1999, when Messrs. Brooks each advanced

$800,000 to the company on open account (referred to collectively

as the $1.6 million advance).   The third advance occurred on

December 29, 2000, when Messrs. Brooks each advanced $1.1 million

to the company on open account (referred to collectively as the

$2.2 million advance).   On January 5, 1999, the company made a

$500,000 repayment to each of Messrs. Brooks (referred to

collectively as the $1 million repayment).    On January 3, 2000,

the company made a $800,000 repayment to each of Messrs. Brooks

(referred to collectively as the $1.6 million repayment).

     As of the close of 1998, the outstanding balance of open

account debt owed by the company to Messrs. Brooks equaled the

amount advanced to the company during 1997; i.e., $1 million.

However, pro rata company losses during 1997 and 1998 had reduced

Messrs. Brooks’s basis in the open account debt to zero.

     When Messrs. Brooks made the $1.6 million advance at the

close of 1999, it was an amount sufficient, in Messrs. Brooks’s

view, to (1) provide a basis offset for the $1 million repayment

and (2) allow for the recognition by Messrs. Brooks of their pro

rata share of company losses incurred during 1999.3

     3
      Petitioners contend that Messrs. Brooks’s bases in the open
account debts were also reduced by offsetting the $1 million
repayment. As discussed below, respondent contends that the
repayment of open account debt may not be offset by the basis of
                                                   (continued...)
                              - 5 -

     When Messrs. Brooks made the $2.2 million advance at the

close of 2000, it was an amount sufficient, in Messrs. Brooks’s

view, to (1) provide a basis offset for the $1.6 million

repayment and (2) allow for the recognition by Messrs. Brooks of

their pro rata share of company losses during 2000.4

     Respondent concedes that Messrs. Brooks’s advances to the

company and the company’s repayments of the advances constituted

open account debt and does not contend that any of the advances

constituted separate indebtedness.    Other than the advances

described above, Messrs. Brooks advanced no money to the company

from 1997 to December 31, 2000.

                           Discussion

     We must decide whether the $1.6 million advance provided

sufficient basis to offset the $1 million repayment on January 5,

1999, in addition to allowing recognition of Messrs. Brooks’s pro

rata share of company losses for 1999, and whether the $2.2


     3
      (...continued)
an open account advance subsequent to the repayment. However,
respondent does not dispute that the $1 million advance provided
Messrs. Brooks with sufficient bases to recognize their
respective pro rata losses for 1999.
     4
      Petitioners contend that Messrs. Brooks’s bases in the open
account debts were also reduced by offsetting the $1,600,000
repayment. As discussed below, respondent contends that the
repayment of open account debt may not be offset by the basis of
an open account advance subsequent to the repayment. However,
respondent does not dispute that the $1,600,000 advance provided
Messrs. Brooks with sufficient bases to recognize their
respective pro rata losses for 2000.
                                - 6 -

million advance provided sufficient basis to offset the $1.6

million repayment on January 3, 2000, in addition to allowing

recognition of Messrs. Brooks’s pro rata share of losses for

2000.

     A lender recognizes income to the extent that repayment of

the debt exceeds the lender’s basis in the debt.     See sec.

1001(a), (c).    Because a lender generally takes a basis equal to

the face amount of the debt, a repayment generally does not

generate taxable income to the lender.    See secs. 1001(a),

1011(a), 1012.    However, taxable income may result from the

repayment of a debt if the lender’s basis in the debt is reduced

from the face amount.    See sec. 1001(a).   If a shareholder

advances money to an S corporation and the shareholder’s pro rata

share of S corporation losses exceeds the shareholder’s basis in

the stock of the S corporation, a reduction in the basis of a

debt may occur.    See sec. 1367(b)(2)(A); sec. 1.1367-2(b), Income

Tax Regs.

     A shareholder of an S corporation must take into account the

shareholder’s pro rata share of the S corporation’s items of

income, loss, deduction, and credit.5    Sec. 1366(a)(1).   Items of

     5
        SEC. 1366(d). Special Rules for Losses and Deductions.--

     (1) Cannot exceed shareholder’s basis in stock and debt.--
The aggregate amount of losses and deductions taken into account
by a shareholder under subsection (a) for any taxable year shall
not exceed the sum of--
                                                   (continued...)
                                 - 7 -

income increase the shareholder’s basis in stock of the S

corporation (stock basis), and items of loss decrease the

shareholder’s stock basis.   Sec. 1367(a).   In the instant case,

Messrs. Brooks each had a zero basis in their stock in the

company at all relevant times.

     Although a shareholder may not reduce stock basis below

zero, a shareholder with a zero stock basis may recognize further

losses to the extent of the shareholder’s debt basis, including

the shareholder’s advances to the S corporation.   See sec.

1366(d)(1).   Section 1367(b)(2)(A) and section 1.1367-2(b),

Income Tax Regs., provide that a shareholder must reduce debt

basis (but not below zero) to the extent that the shareholder’s

pro rata share of losses exceeds the shareholder’s stock basis,

after taking into account any income items for the tax year.6   In

     5
      (...continued)
          (A) the adjusted basis of the shareholder’s stock in
     the S corporation (determined with regard to paragraphs (1)
     and (2)(A) of section 1367(a) for the taxable year), and

          (B) the shareholder’s adjusted basis of any
     indebtedness of the S corporation to the shareholder
     (determined without regard to any adjustment under paragraph
     (2) of section 1367(b) for the taxable year).
     6
      Sec. 1.1367-2(b) Reduction in basis of indebtedness--

     (1) General rule. If, after making the adjustments required
by section 1367(a)(1) for any taxable year of the S corporation,
the amounts specified in section 1367(a)(2)(B), (C), (D), and (E)
(relating to losses, deductions, noncapital, nondeductible
expenses, and certain oil and gas depletion deductions) exceed
the basis of a shareholder’s stock in the corporation, the excess
                                                   (continued...)
                               - 8 -

a year subsequent to such a reduction in debt basis, if the

shareholder’s pro rata share of income exceeds the pro rata share

of losses, section 1367(b)(2)(B) and section 1.1367-2(c), Income

Tax Regs., provide that the excess income shall first restore the

shareholder’s debt basis and then restore the shareholder’s stock

basis.7   The reduction of debt basis pursuant to section

1367(b)(2)(A) and section 1.1367-2(b), Income Tax Regs., and the

     6
      (...continued)
is applied to reduce (but not below zero) the basis of any
indebtedness of the S corporation to the shareholder held by the
shareholder at the close of the corporation’s taxable year. Any
such indebtedness that has been satisfied by the corporation, or
disposed of or forgiven by the shareholder, during the taxable
year, is not held by the shareholder at the close of that year
and is not subject to basis reduction.
     7
      Sec. 1.1367-2(c) Restoration of basis--(1) General rule.
If, for any taxable year of an S corporation beginning after
December 31, 1982, there has been a reduction in the basis of an
indebtedness of the S corporation to a shareholder under section
1367(b)(2)(A), any net increase in any subsequent taxable year of
the corporation is applied to restore that reduction. For
purposes of this section, net increase with respect to a
shareholder means the amount by which the shareholder’s pro rata
share of the items described in section 1367(a)(1) (relating to
income items and excess deduction for depletion) exceed the items
described in section 1367(a)(2) (relating to losses, deductions,
noncapital, nondeductible expenses, certain oil and gas depletion
deductions, and certain distributions) for the taxable year.
These restoration rules apply only to indebtedness held by a
shareholder as of the beginning of the taxable year in which the
net increase arises. The reduction in basis of indebtedness must
be restored before any net increase is applied to restore the
basis of a shareholder’s stock in an S corporation. In no event
may the shareholder’s basis of indebtedness be restored above the
adjusted basis of the indebtedness under section 1016(a),
excluding any adjustments under section 1016(a)(17) for prior
taxable years, determined as of the beginning of the taxable year
in which the net increase arises.
                                - 9 -

restoration of debt basis pursuant to section 1367(b)(2)(B) and

section 1.1367-2(c), Income Tax Regs., are hereinafter

collectively referred to as debt basis adjustments.

     In the instant case, the record reveals that the amount of

the company’s losses in 1997, 1998, 1999, and 2000, exceeded the

amount of the company’s income in each respective tax year.

Consequently, pursuant to section 1.1367-2(b), Income Tax Regs.,

the losses reduced Messrs. Brooks’s respective open account debt

bases at each respective year end.      Respondent does not challenge

petitioners’ recognition of such losses.8

     For the purpose of determining taxable income upon an S

corporation’s repayment of shareholder advances, a separate

transaction involving an advance and repayment of indebtedness is

generally treated separately.   See sec. 1.1367-2(a), (b)(3),

(c)(2), Income Tax Regs.   Shareholders may not offset the

repayment of a shareholder advance with the basis of another

separate shareholder advance.    Cornelius v. Commissioner, 58 T.C.

417 (1972) (discussed further below), affd. 494 F.2d 465 (5th

Cir. 1974).   However, multiple shareholder advances and

repayments that constitute open account indebtedness are treated


     8
      Respondent concedes that the Dec. 31, 1999, open    account
advance provided sufficient debt basis for petitioners    to
recognize the losses claimed in 1999 and that the Dec.    29, 2000,
advance provided sufficient debt basis for petitioners    to
recognize the losses claimed in 2000.
                              - 10 -

as a single indebtedness rather than separate indebtedness.    See

Cornelius v. Commissioner, 494 F.2d 465, 476 (5th Cir. 1974);

sec. 1.1367-2(a), Income Tax Regs.9

     Petitioners contend that the basis of a shareholder’s open

account debt is properly determined at the close of the S

corporation’s tax year by first netting advances and repayments

of open account debt during the tax year and then making any

necessary debt basis adjustments.     Respondent relies on Cornelius

v. Commissioner, 494 F.2d 465 (5th Cir. 1974), for the

proposition that Messrs. Brooks must recognize income on the

repayment of their advances to the extent that the repayments

exceed their basis in the advance on the date of repayment,

without regard to the basis of subsequent advances in the year of

repayment.

     We believe that respondent’s reliance in the instant case on

Cornelius v. Commissioner, supra, is misplaced.    In Cornelius,

the Fifth Circuit Court of Appeals affirmed the finding of this

Court that the advances by the taxpayers to their S corporation



and the repayments of those advances constituted separate and



     9
      Sec. 1.1367-2(a), Income Tax Regs., provides that advances
and repayments of open account debt are treated as a single
indebtedness for the purpose of making debt basis adjustments and
defines open account debt as “shareholder advances not evidenced
by separate written instruments and repayments on the advances”.
                                - 11 -

complete transactions as opposed to open account debt.10

Cornelius v. Commissioner, 494 F.2d at 471.    The Court of Appeals

stated:

          The real question to be decided is whether each
     advance to the corporation by the shareholders and its
     corresponding repayment constitute a separate and
     complete transaction or whether the indebtedness should
     be considered as an “open account” whose fluctuations
     are to be measured for tax purposes at the end of each
     taxable year. * * * The Tax Court properly determined
     that “the 1966 loans and the [1967] repayments thereof
     constituted a completed transaction, and the loans
     occurring later in 1967 were separate and apart from
     such transaction.” * * * [Id.; citation omitted.]

Based on the Tax Court’s finding in Cornelius that the loans were

separate transactions and not open account indebtedness, the

taxpayers were required to recognize as taxable income the amount

of the repayment in excess of the taxpayers’ basis in the advance

at the time of repayment, without regard to the basis of a

subsequent advance in the year of repayment.    Cornelius v.

Commissioner, 58 T.C. at 423.    It may be inferred that a netting

of advances and repayments during the year would have been proper

if the loans had been open account indebtedness rather than

separate transactions.11   Cornelius v. Commissioner, 494 F.2d at

     10
      Pursuant to Bonner v. City of Prichard, 661 F.2d 1206
(11th Cir. 1981), the precedent of the Fifth Circuit Court of
Appeals decided as of Sept. 30, 1981, is followed by the Eleventh
Circuit Court of Appeals, the circuit to which an appeal of this
case, absent stipulation to the contrary, would lie.
     11
      In Smith v. Commissioner, 48 T.C. 872 (1967), affd. in
part and revd. in part on another issue 424 F.2d 219 (9th Cir.
                                                   (continued...)
                               - 12 -

471.    In contrast to Cornelius, the parties in the instant case

have stipulated that the advances in issue constitute open

account debt.    Respondent has made no contention that any advance

and repayment constitutes a separate indebtedness or closed

transaction.

       Based on the parties’ stipulations that the advances were

open account debt and respondent’s failure to contend that any

advance and repayment composed a separate transaction, we hold

that the basis of the open account indebtedness is properly

computed by netting at the close of the year advances of open

account debt during the year and repayments of open account debt

during the year.    Cf. Cornelius v. Commissioner, 494 F.2d 465

(5th Cir. 1974).    Consequently, the advances in 1999 and 2000

shielded petitioners from the realization of gain upon the

repayments during those years.




       We have considered all contentions that the parties have


       11
      (...continued)
1970), respondent did not dispute that advances and repayments of
open account debt were properly netted prior to determining
income on repayment. In that opinion, we stated: “The <net
payment’ approach utilized by petitioners has not been questioned
by respondent.” Id. at 882 n.6.
                               - 13 -

raised.12   To the extent not addressed herein, those contentions

are without merit or unnecessary to reach.

     To reflect the foregoing and concessions by the parties,



                                         Decisions will be

                                    entered under Rule 155.




     12
      We note that the parties have argued extensively regarding
the scope of sec. 1.1367-2, Income Tax Regs. Respondent contends
that the open account debt rule of sec. 1.1367-2(a), Income Tax
Regs., does not apply to the instant case because the shareholder
advances in issue are not allowed restoration of debt basis
pursuant to sec. 1.1367-2(c), Income Tax Regs. Petitioner
contends that the open account debt rule of sec. 1.1367-2(a),
Income Tax Regs., provides for the netting of the advances and
repayments in issue at the close of the tax year for purposes of
determining income on a repayment. Based on our holding above,
we need not address the parties’ contentions concerning sec.
1.1367-2, Income Tax Regs., and leave this issue for another day.
                               - 14 -

                              Appendix

I.   Computation of Debt Bases

     A.   Respondent

     With respect to the 1999 tax year, respondent’s position

results in (1) a debt basis of $358,707 for petitioners in docket

No. 8981-03 at the close of 1999, reflecting a reduction of basis

in the $800,000 advance only by an allowable loss of $441,293,

and (2) a debt basis of $386,056 for petitioners in docket No.

8983-03 at the close of 1999, reflecting a reduction of basis in

the $800,000 advance only by an allowable loss of $413,944 for

petitioners’ 1999 tax year.

     With respect to the 2000 tax year, respondent’s position

results in (1) a debt basis of $718,762 for petitioners in docket

No. 8981-03 at the close of 2000, reflecting a reduction of basis

in the $1,100,000 advance only by an allowable loss of $381,238,

and (2) a debt basis of $703,202 for petitioners in docket No.

8981-03 at the close of 2000, reflecting a reduction of basis in

the $1,100,000 advance only by an allowable loss of $396,798.

     B.   Petitioners

     With respect to the 1999 tax year, petitioners contend that

the basis of each $800,000 advance was first reduced by the

$500,000 repayments on January 5, 1999, and then further reduced

by $300,000 of pro rata company losses, resulting in a zero debt

basis at the close of 1999.
                              - 15 -

      With respect to the 2000 tax year, petitioners contend that

the basis of each $1,100,000 advance was first reduced by the

$800,000 repayments on January 3, 2000, and then further reduced

by $300,000 of pro rata company losses, resulting in a zero debt

basis at the close of 2000.

II.   Computation of Gain

      A.    Respondent

      With respect to the 1999 tax year, respondent determined

that (1) petitioners in docket No. 8981-03 had a taxable gain of

$500,000 related to the repayment of January 5, 1999 ($500,000

repayment less zero debt basis), and (2) petitioners in docket

No. 8983-03 had a taxable gain of $500,000 related to the

repayment of January 5, 1999 ($500,000 repayment less zero debt

basis).13

      13
      Respondent attached to the docket No. 8981-03 statutory
notice of deficiency the following calculation of taxable gain on
debt repayment:

      Computation of Taxable Debt Repayment

      1997 loan from shareholder               500,000
      Less: 1997 loss applied to basis        (195,042)
      Less: 1998 loss applied to the basis    (319,875)
      1997 loan basis                                0
      1999 loan repayment                      500,000
      Taxable gain on loan repayment           500,000

Respondent attached to the docket No. 8983-03 statutory notice of
deficiency the following calculation of taxable gain on debt
repayment:

      Computation of Taxable Debt Repayment
                                                    (continued...)
                             - 16 -

     With respect to the 2000 tax year, respondent determined

that petitioners in docket No. 8981-03 had a taxable gain of

$441,293 related to the repayment of January 3, 2000 ($800,000

repayment less $358,707 debt basis), and that petitioners in

docket No. 8983-03 had a taxable gain of $413,944 related to the

repayment of January 3, 2000 ($800,000 repayment less $386,056

debt basis).14

     B.   Petitioners

     With respect to the 1999 tax year, petitioners contend that

the $800,000 basis of each advance offset the $500,000 repayments

     13
      (...continued)
     1997 loan from shareholder               500,000
     Less: 1997 loss applied to basis        (203,002)
     Less: 1998 loss applied to the basis    (296,998)
     1997 loan basis                                0
     1999 loan repayment                      500,000
     Taxable gain on loan repayment           500,000
     14
      Respondent attached to the docket No. 8981-03 statutory
notice of deficiency the following calculation of taxable gain on
debt repayment:

     “1999” loan from shareholder             800,000
     Less: 1999 loss used against loan       (441,293)
     Basis of 1999 loan                       358,707
     Repayment of loan made in 2000           800,000
     Taxable gain on loan repayment           441,293

     Respondent attached to the docket No. 8983-03 statutory
notice of deficiency the following calculation of taxable gain on
debt repayment:

     “1999” loan from shareholder             800,000
     Less: 1999 loss used against loan       (413,944)
     Basis of 1999 loan                       386,056
     Repayment of loan made in 2000           800,000
     Taxable gain on loan repayment           413,944
                             - 17 -

on January 5, 1999, and also allowed for the recognition of

$300,000 of the pro rata share of the company’s losses.

     With respect to the 2000 tax year, petitioners contend that

the $1,100,000 basis of each advance offset the $800,000

repayments on January 3, 2000, and also permitted each petitioner

to recognize $300,000 of the pro rata share of the company’s

losses.
