                         T.C. Memo. 1996-119



                       UNITED STATES TAX COURT


         CHARLES KADLEC AND LESLEY C. KADLEC, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent


     Docket No.   22506-94.           Filed March 12, 1996.

     Lisa J. Steele, for petitioners.

     Melanie M. Garger, for respondent.


               MEMORANDUM FINDINGS OF FACT AND OPINION


     RUWE, Judge:    Respondent determined a deficiency of $50,115

in petitioners’ 1988 Federal income tax.   Respondent further

determined an addition to tax pursuant to section 6651(a)(1)1 in

the amount of $12,529.


     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable year in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
                                 - 2 -


     After concessions,2 the sole issue remaining for decision is

whether petitioners are entitled to a bad debt deduction of

$182,451.03 for the 1988 taxable year.


                          FINDINGS OF FACT


     Some of the facts have been stipulated and are so found.

The stipulation of facts and attached exhibits are incorporated

herein by this reference.   Petitioners resided in Acton,

Massachusetts, at the time they filed their petition.

     Petitioners are the owners of Stow Laboratories, Inc. (SLI),

a closely held Massachusetts corporation with its principal place

of business in Hudson, Massachusetts.       SLI has been engaged in

the manufacturing and sale of electrical equipment since it was

incorporated on April 4, 1973.    Mr. Kadlec is the president and

treasurer of SLI as well as a director and full-time employee.

He owns 80 percent of SLI's stock.       Mrs. Kadlec is the vice

president, clerk, and a director, and she owns the remaining 20

percent of SLI's stock.   From 1973 to the date of trial,

petitioners made capital contributions to SLI in the total amount

of $250.




     2
      At trial, petitioners conceded the addition to tax pursuant
to sec. 6651(a)(1) for delinquent filing of their 1988 Federal
income tax return.
                              - 3 -


Advances to SLI


     From 1978 through 1982, Yana Kadlec, Mr. Kadlec's mother,

made the following advances to SLI:


 Amount      Date of Note   Maturity Date         Interest Rate

$20,000       3/14/78          3/24/79           11%   per   annum
  10,000     10/15/79         10/24/80           17%   per   annum
  10,000      1/30/80          1/24/81           18%   per   annum
1
  40,000      1/24/82          1/24/83           15%   per   annum

     1
      Petitioners allege that this note is a renewal of the
previous three notes from Yana Kadlec.


Yana Kadlec died on May 13, 1983.   SLI never repaid the principal

due under any of these notes to Yana Kadlec or to her heirs or

assignees.

     From 1979 through 1983, SLI borrowed various sums from

Hudson National Bank (Hudson National) of Hudson, Massachusetts.

Most of the borrowing was in the form of 90-day demand notes.        In

addition, on November 20, 1980, SLI borrowed $20,000 from Hudson

National pursuant to a 3-year collateral note.    Hudson National

required Mr. Kadlec to guarantee these notes.    On April 22, 1981,

SLI’s board of directors ratified Hudson National’s 3-year loan.

The corporate minutes indicate that Hudson National required Mr.

Kadlec to personally countersign the borrowing.    All notes from

Hudson National were paid in full by November 1983.
                                - 4 -


     During each of the years 1981 through 1990, Mr. Kadlec

advanced funds to SLI to enable it to meet its payroll and

current operating expenses.   At the end of each year, the unpaid

balance of the advances was totaled and memorialized in an

interest-bearing promissory note.   Between 1981 and 1985, Mr.

Kadlec advanced the following amounts to SLI:


  Amount       Date of Note     Maturity Date          Interest Rate

$56,090.32       12/31/81        12/31/84              15%   per   annum
 17,664.76       12/31/82        12/31/85              15%   per   annum
 74,512.89       12/31/83        12/31/85              13%   per   annum
  5,111.07       12/31/84        12/31/86              13%   per   annum
 29,071.99       12/31/85        12/31/87              12%   per   annum


The average bank prime rates for the periods at issue were as

follows:


             Year                        Interest Rate

             1981                       18.87%   per   annum
             1982                       14.86%   per   annum
             1983                       10.79%   per   annum
             1984                       12.04%   per   annum
             1985                        9.93%   per   annum


Mr. Kadlec's 1981 and 1982 advances were subordinated to the

then-outstanding Hudson National 3-year loan executed on November

20, 1980.    On April 20, 1982, at a special meeting of SLI’s board

of directors, the board ratified Mr. Kadlec’s 1981 advance.            The

corporate minutes state that funds needed by SLI to continue

operations while SLI developed new products had become impossible
                               - 5 -


to obtain from banks without Mr. Kadlec’s accompanying personal

guarantee.   In addition, at a special meeting on May 6, 1986,

SLI’s board ratified Mr. Kadlec’s 1985 advance.     The corporate

minutes indicate that Mr. Kadlec’s advance was necessary, because

no other sources of funds were available.   SLI has never made any

payments of principal or interest to Mr. Kadlec pursuant to these

notes.

     From 1984 through 1987, SLI subleased office space to

Datatrol, producing rental income as follows:


              Year                     Rental Income

              1984                     $31,033.31
              1985                      65,218.95
              1986                      62,008.39
              1987                      32,168.17


Mr. Kadlec believed that his advances to SLI would be repaid out

of profits generated by product sales and from rental income

received from Datatrol.   The sublease with Datatrol ended in

August 1987, and SLI was unable to find another subtenant until

1990.

     On March 15, 1988, at a special meeting of SLI’s board of

directors, the board declared Mr. Kadlec's promissory notes for

1981 through 1985 worthless.   However, at the same meeting, the

board ratified a note dated December 31, 1987, to Mr. Kadlec in

the amount of $43,900 for money that SLI had borrowed from Mr.

Kadlec.   Mr. Kadlec also made additional advances subsequent to
                                - 6 -


the March 15, 1988, meeting.   These include a $77,000 advance in

1988, an $84,400 advance in 1989, and a $19,350 advance in 1990.

SLI has made no payments on any of these advances.

     SLI was a going concern in 1988 and has continued as such

through the time of trial.

     Petitioners claimed the 1981 through 1985 advances as

"short-term capital losses" on Schedule D of their 1988 Federal

income tax return.   SLI did not file a U.S. Corporate Tax Return

(Form 1120) for the taxable year 1988 and, therefore, did not

report any cancellation of indebtedness income as a result of

these alleged canceled debt obligations.


                               OPINION


     The only issue for decision is whether petitioners may

deduct $182,451.03 in 1988 as a bad debt under section 166.3

Section 166(a) allows taxpayers a deduction for any bona fide

debt which becomes worthless in the taxable year.    A bona fide

debt is a debt that arises from a debtor-creditor relationship

based upon a valid and enforceable obligation to pay a fixed or

     3
      Petitioners claimed a short-term capital loss deduction on
Schedule D of their 1988 Federal income tax return, alleging that
the loans constituted nonbusiness bad debts. Sec. 166(d)
distinguishes between business and nonbusiness bad debts. If the
loss arises from a business debt, it may be deducted in full
against ordinary income; if the loss arises from a nonbusiness
debt, it is treated as a short-term capital loss. Sec. 166(a),
(d). On brief, petitioners now argue that the loans were, in
fact, business bad debts.
                                 - 7 -


determinable sum of money.    Sec. 1.166-1(c), Income Tax Regs.

This is in contrast to a contribution to capital or equity

investment, which is not considered debt for purposes of section

166.    Kean v. Commissioner, 91 T.C. 575, 594 (1988); sec. 1.166-

1(c), Income Tax Regs.    Respondent determined that Mr. Kadlec’s

advances to SLI constituted capital contributions as opposed to

loans.    Respondent's determination is presumed correct, and

petitioners bear the burden of proving otherwise.    Rule 142(a);

Welch v. Helvering, 290 U.S. 111 (1933); Dixie Dairies Corp. v.

Commissioner, 74 T.C. 476, 493 (1980).

       The characterization of advances to a corporation by a

shareholder is a question of fact to be determined from all the

facts and circumstances.     Gilbert v. Commissioner, 262 F.2d 512,

513 (2d Cir. 1959), affg. T.C. Memo. 1958-8; Georgia-Pacific

Corp. v. Commissioner, 63 T.C. 790, 795 (1975).     Courts have

considered the following nonexclusive list of factors in

determining whether advances, such as those involved in the

instant case, are loans or equity investments:


       (1) the intent of the parties; (2) the identity between
       creditors and shareholders; (3) the extent of
       participation in management by the holder of the
       instrument; (4) the ability of the corporation to
       obtain funds from outside sources; (5) the "thinness"
       of the capital structure in relation to debt; (6) the
       risk involved; (7) the formal indicia of the
       arrangement; (8) the relative position of the obligees
       as to other creditors regarding the payment of interest
       and principal; (9) the voting power of the holder of
       the instrument; (10) the provision of a fixed rate of
                               - 8 -


     interest; (11) a contingency on the obligation to
     repay; (12) the source of the interest payments; (13)
     the presence or absence of a fixed maturity date; (14)
     a provision for redemption by the corporation; (15) a
     provision for redemption at the option of the holder;
     and (16) the timing of the advance with reference to
     the organization of the corporation. [Fin Hay Realty
     Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968);
     fn. ref. omitted.]


     These factors are only aids to be used in determining

whether the investment constitutes debt or equity.    Id. at 697.

The touchstone of economic reality is whether "an outside lender

would have made the payments in the same form and on the same

terms.”   Segel v. Commissioner, 89 T.C. 816, 828 (1987).    If the

advances "were far more speculative than what an outsider would

make, the payments would be loans in name only."     Id. (citing Fin

Hay Realty Co. v. United States, 398 F.2d at 697).

     In making our determination, we recognize that heightened

judicial scrutiny is appropriate when shareholders make advances

to their closely held corporations.    As the Court of Appeals for

the Third Circuit noted in Fin Hay Realty Co. v. United States,

supra at 697:


     Where the corporation is closely held * * * and the
     same persons occupy both sides of the bargaining table,
     form does not necessarily correspond to the intrinsic
     economic nature of the transaction, for the parties may
     mold it at their will with no countervailing pull.
     This is particularly so where a shareholder can have
     the funds he advances to a corporation treated as
     corporate obligations instead of contributions to
     capital without affecting his proportionate equity
     interest. * * *
                               - 9 -




     We find that petitioners have failed to carry their burden

of proof.   Our analysis of the advances at issue under the

factors listed above convinces us that these advances were

contributions to capital rather than loans.


Formal Indicia of the Arrangement


     On brief, respondent concedes that Mr. Kadlec's advances

possessed the formal indicia of loans.   The advances were

memorialized by promissory notes specifying the payment of a sum

certain at a fixed maturity date with interest and providing Mr.

Kadlec with the right to enforce payments.    However, allegedly

objective economic indicia of debt, such as consistent

bookkeeping and consistent financial reporting on balance sheets,

are little more than additional declarations of intent, without

accompanying objective economic indicia of debt.    Dixie Dairies

Corp. v. Commissioner, 74 T.C. at 495 (citing Alterman Foods,

Inc. v. United States, 505 F.2d 873, 879 (5th Cir. 1974)).    In

the instant case, the formal indicia surrounding Mr. Kadlec's

advances are overcome by other factors that establish that, as a

matter of economic reality, Mr. Kadlec's advances were capital

contributions.
                              - 10 -



Inability of SLI to Obtain Funds from Outside Sources


     In Segel v. Commissioner, 89 T.C. at 832, we explained that

the focus of this factor "is not simply on the ability of a

corporation to obtain the funds from outside sources; rather, the

focus is whether an outside lender would have lent the funds on

the same or similar terms.”   The record in this case clearly

establishes that an independent outside lender would not have

made the same advances to SLI as did Mr. Kadlec.   The corporate

minutes from a special meeting of SLI’s board of directors on

April 22, 1981, state that Hudson National required Mr. Kadlec to

personally countersign the borrowing.   In addition, corporate

minutes from meetings of SLI’s board of directors on April 20,

1982, and May 6, 1986, indicate that advances from Mr. Kadlec

were necessary, because SLI no longer had any outside sources

available for borrowing.   Presence of this factor indicates that

the advances were contributions to capital.


The Risk Involved


     Advances by a shareholder that are placed at the risk of the

corporation's business are likely to be considered contributions

to capital.   Nassau Lens Co. v. Commissioner, 308 F.2d 39, 47 (2d

Cir. 1962), remanding 35 T.C. 268 (1960); Gilbert v.

Commissioner, 248 F.2d 399, 406-407 (2d Cir. 1957), remanding
                              - 11 -


T.C. Memo. 1956-137; Peraino v. Commissioner, T.C. Memo. 1982-

524, affd. without opinion 742 F.2d 1437 (2d Cir. 1983).

Petitioners stipulated that Mr. Kadlec anticipated repayment of

his advances would come out of the profits from product sales

and, for the 1984 and 1985 advances, from the rental income

generated from the sublease with Datatrol.    Thus, Mr. Kadlec did

not enjoy an expectation of repayment, regardless of the success

of the business.   Gilbert v. Commissioner, supra at 406.    This is

an additional factor pointing to a finding that the advances

constituted contributions to capital rather than loans.


Thin Capitalization


     A corporation’s debt-to-equity ratio compares the

corporation's total liabilities to its stockholders’ equity.

Development Corp. of Am. v. Commissioner, T.C. Memo. 1988-127.

Examining the debt-to-equity ratio enables us to determine

whether a corporation is so thinly capitalized that a business

loss would result in an inability to repay the advance.     Such

thin capitalization would be indicative of a capital contribution

rather than a loan.   Bauer v. Commissioner, 748 F.2d 1365, 1369

(9th Cir. 1984), revg. T.C. Memo. 1983-120.   Despite numerous

judicial opinions on this issue, no clear cut set of standards or

agreed-upon mathematical formula exists to determine whether or
                                - 12 -


not a corporation is thinly capitalized for Federal income tax

purposes.    Development Corp. of Am. v. Commissioner, supra.

     According to petitioners’ expert, Robert J. Erickson, SLI's

debt-to-equity ratios for the years ending December 31, 1981

through 1985, were as follows:


            December 31           Debt        Equity

               1981            6.647620 to   1.000000
               1982               negative   equity
               1983               negative   equity
               1984               negative   equity
               1985               negative   equity


We believe that SLI’s debt-to-equity ratios for these years,

coupled with the fact that petitioners’ total capital

contribution since 1973 was only $250, indicate that SLI was

thinly capitalized.    Such thin capitalization suggests that the

advances were equity investments.

Subordination


     Whether the advances have a status equal to or inferior to

that of regular corporate creditors is of some importance in

determining whether Mr. Kadlec was dealing as a shareholder or as

a creditor.     United States v. Henderson, 375 F.2d 36, 40 (5th

Cir. 1967); Nassau Lens Co. v. Commissioner, 308 F.2d at 47.       In

the present case, Mr. Kadlec's advances to SLI in 1981 and 1982

were subordinated to the then-outstanding 3-year loan from Hudson
                                - 13 -


National that was executed on November 20, 1980.   This factor

indicates that the advances were capital contributions.


Interest Payments


     A bona fide lender is concerned with interest.    National

Carbide Corp. v. Commissioner, 336 U.S. 422, 435 n.16 (1949);

Curry v. United States, 396 F.2d 630, 634 (5th Cir. 1968).

Mr. Kadlec’s purported debt instruments contained provisions for

interest.   However, SLI has never paid interest (or principal) on

any of the advances in issue.    The fact that Mr. Kadlec continued

to advance funds, despite SLI’s failure to make any interest (or

principal) payments due on these advances, suggests that Mr.

Kadlec made an equity contribution.

     Our review of the record convinces us that an outside

creditor would not have made the advances in issue to SLI.     Segel

v. Commissioner, 89 T.C. 816, 828 (1987).   We conclude that these

advances were contributions to capital as opposed to bona fide

debts; therefore, petitioners are not entitled to a bad debt

deduction for 1988.4


     4
      We note that even if the advances were loans, petitioners
would still not be entitled to a bad debt deduction, because they
have not proven that the advances became worthless in 1988.
Mueller v. Commissioner, 60 T.C. 36, 41 (1973), affd. in part,
revd. in part and remanded 496 F.2d 899 (5th Cir. 1974). Mr.
Kadlec continued to advance funds to SLI, which has continued as
a going concern. Where a debtor company continues to operate as a
                                                   (continued...)
                             - 14 -


     Accordingly, respondent’s determination is sustained.



                                      Decision will be entered

                              for respondent.




     4
      (...continued)
going concern, courts often have concluded that its debts are not
worthless for Federal income tax purposes. Roth Steel Tube Co.
v. Commissioner, 620 F.2d 1176, 1182 (6th Cir. 1980), affg. 68
T.C. 213 (1977).
