                          T.C. Memo. 2001-220



                        UNITED STATES TAX COURT



    BRAZORIA COUNTY STEWART FOOD MARKETS, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 1037-99.                Filed August 14, 2001.



     George W. Connelly, Jr., and William O. Grimsinger, for

petitioner.

     Richard T. Cummings, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     GERBER, Judge:     Respondent determined deficiencies in

petitioner’s Federal income tax for its fiscal tax years ended

September 30, 1991, 1992, and 1994, of $216,552, $225,336, and

$8,190, respectively.    The sole issue for our consideration is

whether bad-debt deductions taken in 1994 are allowable under
                                - 2 -

section 166.1   The remainder of respondent’s deficiency

determinations resulted purely from computational adjustments

caused by the disallowance of petitioner’s ordinary loss

deduction.

     Petitioner contends that, in form and substance, the

advances were loans that became worthless and deductible.

Respondent’s disallowance of the claimed bad-debt loss was

grounded on the same position that respondent maintains in this

litigation; i.e., petitioner’s advances to a related corporation,

Used Power Equipment, Inc. (UPE), were equity investments in UPE

and there was no intention for UPE to repay the advances.    In

support of his position, respondent questions the validity,

credibility, and enforceability of petitioner’s promissory notes

and contends UPE was insolvent at the time the advances were

made.    Respondent ultimately contends that the advances were

contributions to capital made to further petitioner’s sole

shareholder’s control of and investment in UPE, the loss of which

is a capital loss deductible only to the extent of capital gains

under section 1211.




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

                           FINDINGS OF FACT2

     Petitioner, Brazoria County Stewart Food Markets, Inc., was

incorporated in Texas on March 27, 1981.       Petitioner’s place of

business at the time the petition was filed was Brazoria, Texas.

Petitioner, a subchapter C corporation, operates grocery stores.

Vernon Stewart (Stewart) is petitioner’s chief executive officer

and sole shareholder.     Stewart founded petitioner as a sole

proprietorship in 1975, after his purchase of a small grocery

store.     The first grocery store was successful, and within a year

two additional small grocery stores were acquired.      After a loss

of business due to competition, the first store was closed.

Petitioner operated as many as five small grocery stores at one

time.     Ultimately, only the two most profitable stores were

expanded into supermarkets and survived.

         Grocers Supply Co. (Grocers), a large wholesale distributor

of grocery products to independent grocery stores in and around

Houston, Texas, was petitioner’s primary supplier of grocery

products.     In addition to its business as a distributor of

grocery products, Grocers frequently made loans to its customers

for working capital, store renovation, expansion, and other

purposes.     Grocers’ loans were made at competitive rates and were

normally secured by the borrower’s inventory, furniture,


     2
       The parties’ stipulation of facts and exhibits is
incorporated herein by this reference.
                               - 4 -

fixtures, receivables, and other assets.   Grocers was owned by

Max and Milton Levit, and its chief financial officer was James

Nelson (Nelson).   Petitioner’s and UPE’s loan requests of Grocers

and loan renegotiations were subject to the approval of Milton

Levit.   When a loan request was approved, Nelson became

responsible for its management and collection.    It was Grocers’

policy not to become involved in the operation of retail stores

or to become an equity investor or stockholder.    If a borrower

defaulted without satisfactory means of repayment, Grocers

enforced its security interest by taking possession of the

secured assets and liquidating them.   Some of petitioner’s early

stores were purchased from and/or with financial assistance from

Grocers.   Petitioner acquired small stores from Grocers and/or

its debtors after the debtors’ default on their obligations to

Grocers.

     Once petitioner was firmly established in the supermarket

business, Stewart used petitioner’s capital to diversify into the

purchase and sale of used industrial equipment.    Stewart

incorporated UPE in Texas during 1987 to sell salvaged equipment

that had been removed from industrial plants.    Most of UPE’s

salvaged materials consisted of powerhouse and ethylene plant

equipment.   A substantial portion of UPE’s operating expenses was

due to the cost of labor, cleanup, and storage for equipment.
                                 - 5 -

     Initially, UPE had three stockholders, Stewart, Kelso Vernor

(Vernor), and Joseph Busch (Busch).      Their collective initial

capital contribution to UPE was $1,000, with each of the three

shareholders receiving one-third of the common stock.      Mickey

Goolsby (Goolsby) was hired as UPE’s president to run the day-to-

day operations.

     Vernor was a demolition expert, and before UPE’s

incorporation, he had been awarded a salvage contract by Dow

Chemical Co. (Dow).    Vernor contributed the Dow contract to UPE.

Under the contract, Dow agreed to exchange equipment and its

accompanying paperwork and support parts for UPE’s removal of the

equipment from Dow’s premises.    The Dow contract provided UPE

with an inventory of used equipment.      Busch, who was familiar

with the salvaged equipment, was responsible for cataloging the

parts and machinery.   In addition, Busch had a working knowledge

of the international markets for used equipment, and he was to

seek the highest price for UPE’s salvaged equipment.

     Stewart was responsible for securing capital for UPE.      As

petitioner’s sole shareholder, Stewart directed petitioner to

make a number of advances of working capital to UPE.      Some of the

advances came from petitioner’s operating capital, but most

advances were from the proceeds of petitioner’s loans from

Grocers.   Stewart personally guaranteed the only loan that UPE

had made directly with Grocers.
                               - 6 -

     On October 1, 1987, petitioner made two advances for

operating capital to UPE in the amounts of $100,000 and $80,622,

respectively.   The advances from petitioner to UPE were not

contemporaneously memorialized in promissory notes.

     During 1987, 1988, and 1989, UPE obtained several salvage

jobs, sold some of its inventory, and brokered a deal that netted

$450,000 in commission fees; however, UPE reported losses for

those tax years.   Stewart, however, desired to expand UPE’s

operation beyond salvage and used equipment sales, and in 1990,

UPE entered into a short-term industrial construction venture

with Formosa Plastics Corp. U.S.A. (Formosa).

     After a feasibility study, it was determined that the

Formosa venture could be profitable because UPE’s labor force

already had the necessary skills for performance.    UPE bid on and

was awarded six contracts (the Formosa contracts) valued at

$8,430,963.   UPE did not seek legal counsel at the time the

contracts were executed, and the terms of the contracts were

unfavorable to UPE and favorable to Formosa.    UPE expected a

profit of at least 10 percent from the Formosa contracts.

     Under the Formosa contracts, UPE was required to supply the

labor, tools, and equipment necessary for the installation of

piping and turbines.   Formosa was to supply the pipe and the

turbines and make progress payments at various stages of

completion.   UPE planned to use the progress payments to pay for
                                - 7 -

the costs of completion, but UPE did not have sufficient capital

to finance the initial costs of labor and equipment.

     Under Stewart’s direction, petitioner requested and received

three separate loans from Grocers and, in turn, petitioner

advanced the proceeds to UPE.   Grocers made each of its loans to

petitioner with the knowledge that UPE would receive the

proceeds.   The loans were structured this way because of Grocers’

concerns about collateral and UPE’s ongoing ability to service

the indebtedness.   Petitioner did not attempt to obtain any of

its loans from a source other than Grocers.   In addition to the

advances from petitioner, UPE obtained its own separate loan from

Grocers.    UPE did not attempt to obtain its loan from any source

other than Grocers.

     On March 7, 1990, the first loan, in the amount of $250,000,

was extended from Grocers to petitioner and was secured by

petitioner’s inventory, cash, checks, and receivables.   The loan

was designated for UPE’s use as working capital.    The proceeds,

in turn, were advanced to UPE without promissory notes from UPE

to petitioner.   On August 30, 1990, UPE paid off the balance of

the $250,000 loan from Grocers.

     Stewart was optimistic about UPE’s future, and he believed

that the Formosa job would be a quick fix to UPE’s cashflow

problems.   UPE’s recurring losses and related problems caused

Vernor and Busch to disagree with Stewart, and they were not
                                 - 8 -

prepared to go along with UPE’s new venture.    On April 30, 1990,

Stewart arranged for a second loan from Grocers to petitioner in

the amount of $475,000.    The loan proceeds were, in turn,

advanced to UPE and/or used in connection with UPE as follows:

$300,000 for UPE’s working capital; $100,000 for the purchase of

UPE’s equipment; and $75,000 to buy out Vernor’s and Busch’s

interests and shares in UPE.    Petitioner’s loan from Grocers was

secured by petitioner’s inventory, cash, checks, and receivables.

The proceeds were advanced to UPE without a note.

     In May of 1990, Vernor’s and Busch’s UPE shares were

redeemed with $75,000 from petitioner’s $475,000 loan from

Grocers.    After the other two shareholders were bought out,

Stewart named himself president and demoted Goolsby from

president to vice president.

     After Stewart gained control of UPE, he negotiated a loan

from Grocers.    Although it was not Grocers’ normal business

practice to lend money to entities outside of the grocery

industry, UPE requested and received a loan in the amount of

$218,000 on September 5, 1990.    That loan was designated for the

purchase of construction equipment, and Grocers received a

security interest in UPE’s equipment.    A $111,984.67 balance

remaining on UPE’s loan from Grocers was eventually satisfied by

petitioner when UPE and Stewart could no longer afford to repay

the debt.
                               - 9 -

     As the Formosa construction progressed, it became clear that

UPE’s expenses were higher than Stewart had anticipated, and

UPE’s performance under the contracts required an additional

infusion of capital.   On October 11, 1990, Stewart negotiated a

third loan from Grocers to petitioner in the amount of $300,000.

That loan, which was in turn advanced to UPE, was designated for

use as UPE’s working capital but secured by petitioner’s

fixtures, equipment, machinery, furniture, inventory, cash, and

receivables.

     The three loans from Grocers to petitioner, and the loan

from Grocers to UPE, were personally guaranteed by Stewart and

bore interest at 10 percent.

     Petitioner’s certified public accountants, Everett Enoch

Kennemer III (Kennemer) and Marylin C. Anderson of the accounting

firm Kennemer, Masters, Koester & Wallace, L.L.C., advised

petitioner in its tax matters and also prepared financial

compilations weekly and sometimes quarterly.   Kennemer was

intimately familiar with petitioner’s business.   In addition to

advising petitioner, Kennemer’s firm also provided accounting

services for UPE.

     Petitioner did not notify its accountant about the advances;

and although petitioner is an accrual method taxpayer, there was

no interest increase on petitioner’s books allocable to the UPE

advances.   No interest income from the advances was reflected on
                              - 10 -

petitioner’s Federal income tax returns for the years in issue.

No interest expenses from the advances were reflected on UPE’s

Federal income tax returns.

     Although UPE received progress payments from Formosa

totaling $7,778,963, it could not complete any of the

construction projects.   Rain delays, equipment supply problems,

and change orders slowed UPE’s progress.   In April 1992, Formosa

gave UPE written notice of intent to terminate the contracts.

UPE ceased operations, and on April 24, 1992, UPE brought suit

against Formosa in the U.S. District Court for the Southern

District of Texas, Victoria Division, Civil Action No. V-92-16.

     In its lawsuit against Formosa, UPE claimed $2,082,000 in

damages, alleging that Formosa failed to pay amounts due on

contracts and that UPE had suffered damages from Formosa’s delays

and hindrance.   In settlement, UPE and Formosa entered into a

formal agreement under which Formosa agreed to pay UPE $700,000

in full satisfaction of all claims.    In 1994, UPE received a net

recovery of $227,113.97.   After the settlement, UPE ceased

operations and sold its inventory of used equipment for scrap

metal.

     On its 1994 Form 1120, U.S. Corporation Income Tax Return,

petitioner claimed the outstanding advances to UPE as a bad-debt

deduction.   Attached to petitioner’s 1994 tax return was a Form

8275, Disclosure Statement, on which petitioner claimed that
                               - 11 -

$1,352,433 of unrecoverable debt was attributable to its advances

to UPE.   Included within petitioner’s claimed deduction was the

amount of $111,984.67, which represented the balance on UPE’s

loan from Grocers that petitioner had paid off.   The deduction

was the basis for a claimed net operating loss that was carried

back to petitioner’s 1991 and 1992 tax years.

                               OPINION

     The sole issue we consider is whether petitioner is entitled

to a business bad debt deduction for its 1994 tax year.3    Bad

debts that become worthless within the taxable year are

deductible by a corporate taxpayer as ordinary losses under

section 166(a).   The right to a deduction is limited to genuine

debt, and specifically, contributions to capital are not

considered debt for the purposes of section 166(a)(1).     See

Raymond v. United States, 511 F.2d 185, 189 (6th Cir. 1975); sec.

1.166-1(c), Income Tax Regs.   Before a bad debt deduction may be

taken under section 166(a), a taxpayer must establish the


     3
       At trial, near the conclusion of petitioner's case-in-
chief, petitioner’s counsel stated that petitioner would not be
relying on the alternative theory that petitioner was entitled to
interest expense deductions under sec. 163. As a result,
respondent limited his cross-examination of at least one of
petitioner's witnesses and rested without offering any witnesses
of his own. Thereafter, petitioner resurrected and argued the
sec. 163 issue on brief in spite of its concession at trial.
Such behavior is impermissible and prejudicial to respondent.
Accordingly, petitioner is precluded from urging its alternative
theory under sec. 163. See Seligman v. Commissioner, 84 T.C.
191, 198-199 (1985).
                              - 12 -

validity of the debt and show that the advances were loans rather

than capital contributions.   See Rule 142(a); Welch v. Helvering,

290 U.S. 111 (1933).   We consider here whether petitioner’s

advances to UPE created bona fide indebtedness or whether

petitioner’s advances were contributions to capital

representative of an equity stake in UPE.

     The determination of whether advances to a corporation have

created bona fide indebtedness depends on whether there is an

intention to create an unconditional obligation to repay the

advances.   See Raymond v. United States, supra at 190.   Because

bad debt deductions affect ordinary income and equity losses

affect capital gain income, there appears to be a preference for

bad debt deductions.   There has been much litigation on this

subject, and the courts consider various factors when deciding

whether advances are debt or equity.   The Court of Appeals for

the Fifth Circuit, to which this case is appealable, considers at

least 13 nonexclusive factors principally relevant in determining

whether advances to a corporation have created debt or equity.

See Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir.

1972).4

     4
       The Estate of Mixon factors include: (1) The names given
to the certificates evidencing the indebtedness; (2) whether
there is a fixed maturity date; (3) the source of the payments;
(4) whether repayment is legally enforceable; (5) whether the
creditor may participate in the debtor’s management; (6) whether
the obligation is subordinate to other debts; (7) the intent of
                                                   (continued...)
                                - 13 -

     While Estate of Mixon provides a framework for analysis,

great flexibility in its application is permitted.   The factors

are not of equal importance, and no single factor is controlling.

See Dillin v. United States, 433 F.2d 1097, 1100 (5th Cir. 1970).

The object of the inquiry is not to count factors, but to

evaluate them.5   Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir.

1969).   The facts and circumstances of each case must be

considered, and no single factor is considered determinative.

See John Kelly Co. v. Commissioner, 326 U.S. 521, 530 (1946);

Segel v. Commissioner, 89 T.C. 816, 827 (1987).   “The various

factors * * * are only aids in answering the ultimate question

whether the investment, analyzed in terms of its economic

reality, constitutes risk capital entirely subject to the

fortunes of the corporate venture or represents a strict debtor-

creditor relationship.”   Fin Hay Realty Co. v. United States, 398

F.2d 694, 697 (3d Cir. 1968).

     4
      (...continued)
the parties; (8) the debtor’s capitalization and use of the
funds; (9) the identity of interest between creditor and
stockholder; (10) whether interest was paid; (11) the ability of
the corporation to obtain loans from outside lending
institutions; (12) the extent to which the advance was used to
acquire capital assets; and (13) the failure of the debtor to
repay on the due date or to seek a postponement. See Estate of
Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972).
     5
       In this case we have considered all of the factors set
forth in Estate of Mixon. Only certain of the factors, however,
are germane to the factual scenario presented in the record. We,
accordingly, analyze those factors that are significant to the
evaluation of whether petitioner’s advances were debt or equity.
                               - 14 -

     Ultimately, the issue for our consideration is whether

petitioner and UPE intended to create indebtedness with a

reasonable expectation of repayment and whether those aspects

comported with economic reality.    See Estate of Mixon v. United

States, supra at 407.   Generally, shareholders place their money

at the risk of the business while lenders seek a more reliable

return.   See Midland Distribs., Inc. v. United States, 481 F.2d

730, 733 (5th Cir. 1973).    In the setting of this case, it

appears that petitioner either advanced capital to UPE at

Stewart’s direction and/or that petitioner was a conduit for

UPE’s loans from Grocers.    UPE did not have sufficient capital

assets to satisfy the security requirements of Grocers.    In that

regard, Grocers was a true lender, and it sought to profit from

interest income and required security to protect its loan

principal.   Petitioner’s actions here do not reflect an intent to

lend for profit.   Petitioner’s advances to UPE exposed it to the

risks of UPE’s business.    In essence, petitioner was Stewart’s

instrumentality for equity investment in UPE.

     Petitioner contends that its advances to UPE were

commercially reasonable arm’s-length transactions.    However,

petitioner has failed to support this contention.    In an arm’s-

length debtor-creditor relationship, a creditor expects to be

repaid whether the debtor does well or poorly at his business.

If the debtor does poorly, the creditor expects to be repaid from
                               - 15 -

capital.    Where there is no capital, the creditor is exposed to

the risks of a shareholder, not a lender.    Calumet Indus., Inc.

v. Commissioner, 95 T.C. 257, 288 (1990).

       Grocers’ loans to petitioner were secured by petitioner’s

assets, whereas petitioner’s advances were exposed to the risks

of UPE’s business.    We find it significant that petitioner’s and

UPE’s financial records did not show the advances as loans or

debt.    In that regard, petitioner is an accrual method taxpayer,

but no interest was reflected on petitioner’s books or Federal

income tax returns with respect to the advances to UPE.

Petitioner’s accountants/return preparers testified that it would

have been appropriate to report interest income.    The

accountants, however, were unaware of petitioner’s advances to

UPE.    Similarly, no interest expenses from the advances were

reflected on UPE’s Federal income tax returns.    When a corporate

contributor does not seek or pursue interest on its contribution,

its gain, if any, would more likely be from a share of profits

and/or increase in the value of its shareholdings.    See Estate of

Mixon v. United States, supra at 409.

       In the same manner as petitioner’s and UPE’s failure to book

the advances, the habitual postponement of UPE’s obligation to

repay is telling.    That is especially so here, where UPE had

ample opportunity to repay petitioner from progress payments

received from Formosa.    We note that approximately 93 percent of
                               - 16 -

the total amount expected was received from Formosa whereas the

repayments of many of petitioner’s advances were postponed for 3

or more years, and some were never repaid.    Postponement of this

magnitude overtly suggests that petitioner’s advances were

purposefully and systematically subordinated in favor of those of

other creditors, including Grocers, in an effort to keep

petitioner’s and Stewart’s investment in UPE viable.

     Here, petitioner was wholly owned by Stewart, who eventually

used petitioner’s resources to acquire 100 percent of UPE.     A

portion of the advances UPE received from petitioner was used to

buy out the other owners of UPE common stock, making Stewart the

sole shareholder of both petitioner and UPE.    Upon gaining

control of UPE, Stewart made himself president and demoted

Goolsby to vice president.

     Another factor weighing heavily against petitioner is the

fact that UPE was thinly capitalized ($1,000) and reported losses

at the time of all advances.    To counter this factor, petitioner

argues that UPE’s inventory was worth more than $100 million at

the time of the advances.    Both Stewart and Goolsby testified

that UPE’s inventory was probably worth millions of dollars, but

that value depended upon the ability to tap the international

market.   They also pointed out that UPE did not reflect the

equipment’s fair market value on its books because of a lack of

basis.    In light of the record, we find their testimony to be
                               - 17 -

self-serving and unconvincing.    There was no appraisal of UPE’s

inventory.    The witnesses estimated the value on the basis, in

great part, of a one-time brokered sale of two turbines for

$14,500,000 in which UPE received a $450,000 fee.    Petitioner has

not shown that its inventory was similar to the example used by

the witnesses.    There is little in the record to show exactly the

type of equipment in UPE’s inventory and/or that the equipment

was in good working order.

     Significantly, UPE’s inventory was sold locally, only a few

years later, for scrap.    Grocers made one loan directly to UPE

with its equipment as security.    All other loans from Grocers

went through petitioner.    It is likely that Grocers would not

lend more directly to UPE because of UPE’s lack of capital for

security.    The value of UPE’s inventory was, therefore,

insufficient to provide security for a loan or improve UPE’s

financial picture at the time of the advances.    Accordingly, even

if the inventory had been pledged by UPE as security for

petitioner’s advances, it would have been insufficient to provide

the security that a creditor would require.

     Without petitioner’s advances, UPE would have been unable to

continue the salvage operations, purchase equipment, or perform

under the Formosa contracts.    UPE reported a loss during every

year of its existence.    Even after it began receiving progress

payments from Formosa, UPE needed large infusions of capital
                             - 18 -

simply to maintain its construction operations.   Petitioner

contends that the advances were not used to acquire capital

assets; however, before its venture into the construction

business, UPE did not possess the equipment that it needed to

perform its construction obligations under the Formosa contracts.

UPE, at its inception, used some of petitioner’s advances to

acquire capital assets at the startup of UPE.   See Plantation

Patterns, Inc. v. Commissioner, 462 F.2d 712, 722 (5th Cir.

1972), affg. T.C. Memo. 1970-182.   “Providing the bulk of the

necessary first assets without which a corporation could not

begin functioning is as traditional a usage of capital

contributions as is purchasing ‘capital assets’.”     Slappey Drive

Indus. Park v. United States, 561 F.2d 572 (5th Cir. 1977).

     In an attempt to show that the advances were bona fide

indebtedness, petitioner, at trial, offered 24 separate

promissory notes reflecting interest and maturity dates.      The

promissory notes petitioner relied on were prepared for purposes

of trial in an attempt to show the type of notes that were

allegedly executed at the time of the advances.     Stewart

testified that original notes were prepared at the time of the

advances, but that, alternatively they were lost, or could not be

located or may have been destroyed in a 1991 UPE office fire.

Although he signed all 24 of the reconstructed notes offered at

trial, Stewart could not remember the circumstances under which
                               - 19 -

the alleged original notes were created or identify the person

who created them.    Stewart also testified that at least two of

the original notes had a 12-percent rate of interest.    In that

regard, the reconstructed notes reflected 10 percent interest.

On this record, it would be difficult to find that notes were

executed at the time that petitioner advanced funds to UPE.

Considering the failure to advise the accountants of the

advances, failure to book interest income, and failure to book

the advances as loans, it is unlikely that petitioner went

through the formality of notes at the time the funds were

advanced to UPE.    Even if we were able to find that such notes

contemporaneously existed, the substance of the financial

transactions, on this record, reflects that the advances were

equity and not loans.

     Another important fact is that the alleged promissory notes

from UPE to petitioner were not secured by its tangible assets or

guaranteed by its shareholders.    Petitioner contends that the

alleged notes were secured by UPE’s rights to payment under the

Formosa contracts.    Accordingly, the possibility of “repayment”

would have depended solely upon UPE’s receipts from the Formosa

contracts and then only to the extent that creditors were paid

off and/or UPE had profits from which to repay petitioner.    At

the time of the advances, the work on the Formosa contracts had

not yet been performed, and Formosa’s payments to UPE were
                                - 20 -

contingent on UPE’s progress.    Regarding the actual contracts,

UPE’s attorney wrote the following in a letter to petitioner’s

accountant:   “At the time the [Formosa] contracts were entered,

UPE did not seek legal counsel and the contracts were very

onerous to UPE and favorable to Formosa.”      When testifying about

which of the Formosa contracts secured the alleged promissory

notes, Stewart could not identify any of them.

     As shown by their actions, the parties intended the funds

advanced to be an investment in UPE.     For these reasons, we find

that petitioner made an equity investment in UPE and, therefore,

when UPE failed to repay, petitioner suffered a capital loss.

See Kean v. Commissioner, 91 T.C. 575, 594-600 (1988).

     We have considered all other arguments advanced by the

parties, and to the extent that we have not addressed these

arguments, we consider them irrelevant, moot, or without merit.

     To reflect the foregoing,

                                      Decision will be entered for

                                 respondent.
