                          T.C. Memo. 1999-151



                        UNITED STATES TAX COURT



          AUGUST V. AND MARY E. KLAUE, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 13941-97, 20041-97.      Filed May 4, 1999.



     Lowell V. Ruen, for petitioners.

     Sandra Veliz, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     PARR, Judge:     In two notices of deficiency, respondent

determined deficiencies in petitioners' Federal income tax for

1993 and 1994 in the amounts of $24,336 and $53,822,

respectively.    These cases were consolidated for trial, briefing,

and opinion by order of this Court dated February 12, 1998.
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     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the taxable years in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.   All dollar amounts are rounded to the

nearest dollar, unless otherwise indicated.   References to

petitioner are to August V. Klaue.

     The issues for decision are whether petitioners are entitled

to a nonbusiness bad debt deduction of $266,323 in 1993; and if

so, whether they are entitled to a capital loss carryover in the

amount of $184,138 in 1994.   We hold they are to the extent set

out below.1

                          FINDINGS OF FACT

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

The stipulated facts and the accompanying exhibits are

incorporated into our findings by this reference.    At the time

the petitions in these cases were filed, petitioners resided in

Spokane, Washington.

     Petitioner is a sophisticated businessman, and at the time

of trial he was chairman of the board of five corporations which

were engaged in banking, lumbering, and aviation.    In the mid-

1970's, petitioner befriended Roger Estes (Estes).    Estes is an


     1
      Respondent determined that for the years at issue certain
computational adjustments should be made which would reduce
petitioners' itemized deductions. The parties can make these
adjustments in their Rule 155 computation.
                               - 3 -


inventor and in 1980 held approximately 45 patents.   Petitioner

believed that one of Estes' inventions, the Theratech

thermotherapy unit (Theratech device or the device), had

potential to be a financial success.   The Theratech device

relieved the suffering caused by hemorrhoids without surgery.

Petitioner used the device many times and was impressed with its

efficacy, and he believed that with proper marketing it could be

a moneymaker.   As the inventor of the device, Estes held many

shares of stock in the Theratech Co., which had the right to

manufacture and sell the device.

     On December 11, 1980, petitioner entered into a partnership

agreement with Estes and created K & E Associates (the

partnership).   The partnership was created to finance a gold-

dredging operation in the Columbia River.   On January 16, 1981,

the partnership borrowed $175,000 from Old National Bank (the

bank), and petitioner and Estes as individuals and general

partners of the partnership executed a promissory note in favor

of the bank in that amount.   Estes pledged 100,000 shares of

Theratech2 stock as collateral for the loan.   Petitioner did not

pledge any collateral.   Estes authorized the bank to deliver the

stock to petitioner if petitioner paid the balance of the loan.




     2
      At the time Estes pledged this stock, the name of the
company was Bio-tronics.
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At the time Estes pledged the stock, it had a value of

approximately $200,000 ($2 per share).

     On September 2, 1981, petitioner and Estes as individuals

and general partners of the partnership obtained an additional

loan of $70,000 and executed a promissory note in favor of the

bank for $245,000.   This promissory note incorporated the

previous promissory note and the additional loan amount.     On

December 8, 1981, petitioner and Estes returned to the bank and

obtained a loan of $50,000 and executed a promissory note in

favor of the bank in their individual and general partner

capacities.   Neither partner pledged any collateral for these

loans.

     On December 8, 1982, the partnership's loan balance was

$294,000, and it owed the bank $59,762 of accumulated interest.

On this date, petitioner paid $353,762 to the bank in full

satisfaction of the promissory notes, and the bank released the

100,000 shares of Theratech stock to petitioner.    At the time the

bank released the stock, it had a value of approximately $1 per

share.

     Also on this date, Estes signed a promissory note in favor

of petitioner for $176,881.    The note provided for 10-percent

interest per annum and payment in full on December 8, 1983, and

thereafter on demand of holder.    The partnership ceased all

business activities in 1982.
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         The collapse of the gold-dredging venture and the transfer

of the Theratech stock to petitioner in 1982 placed Estes in

financial trouble.   Expecting Estes to repay his debt to

petitioner by selling the Theratech stock, petitioner placed the

stock in a joint account that he opened with Estes at a local

securities brokerage.   Petitioner and Estes sold the shares in

small amounts to maximize its sale value.

     Although petitioner knew that Estes was experiencing

financial difficulty, petitioner believed that once the Theratech

device became a financial success, Estes would be able to repay

the amount petitioner had lent him.     Accordingly, rather than

attempting to collect the outstanding loan amounts, petitioner

advanced Estes additional sums, for which Estes signed promissory

notes.    Estes signed promissory notes for $52,381 on December 8,

1982; $12,534 on August 10, 1983; $5,000 on July 13, 1984; $4,000

on August 2, 1984; $2,000 on October 18, 1984; $3,135 on April 2,

1985; $300 on April 26, 1985; and $3,000 on June 28, 1985.

Whenever petitioner advanced sums to Estes, petitioner or his

secretary made a photocopy of the check for his records.

Petitioner provided these additional amounts because he thought

he needed Estes to promote the Theratech device.     Estes used the

money for living expenses.

     Although these additional advances were evidenced by

promissory notes signed by Estes and were payable on demand, only
                                 - 6 -


the notes signed during 1984 stated an interest rate.    Petitioner

and Estes never executed any written loan agreements other than

the promissory notes.    On September 6, 1989, Estes signed new

promissory notes to refresh the earlier notes, including a note

for $12,000 that Estes had borrowed from petitioner in 1981.      The

new promissory notes provided that interest was due from the date

of the original loan, and that payment was due as of the date of

signing or upon demand.    Estes made no payments of either

interest or principal on these notes, and petitioner made no

demand for payment until 1993.

     During 1982, the Theratech device was being manufactured;

however, the company producing the device was unable to market it

in the United States because of FDA restrictions.    As a result of

the marketing problems the Theratech stock suffered a precipitous

decline in value and was soon trading for much less than $1 per

share.   Sometime between 1985 and 1987, Estes received a letter

from the Beijing Pharmaceutical Institute in Beijing, China.      In

China, the Theratech device was being used experimentally to

treat rectal cancer.    After a high-level Chinese Government

official used the device and was cured of rectal cancer, he

offered Estes the contract to build the Imperial Palace Hotel.

Although Estes knew nothing about building a hotel, petitioner

and a mutual acquaintance, who was an architect, did know about

such development projects.    Seeing an opportunity to revive
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Estes' debt, petitioner, Estes, and the architect went to Beijing

to investigate the hotel project and the market for the Theratech

device.

     Unfortunately, shortly after the party returned to the

United States, and before any contracts were signed, the

architect died.   No further attempts were made to market the

device in China, and the Theratech stock soon became worthless.

     In 1993, petitioner demanded payment on the notes.    Estes,

however, was in the middle of a divorce, was without funds and

living in the home of a relative, and was considering filing for

bankruptcy.   Estes transferred the title of his only asset, a

power boat, to petitioner.   Upon the advice of his attorney,

petitioner decided that it would be futile to make further

attempts to collect on the notes.

     Petitioners claimed a deduction on their 1993 return for a

$266,323 nonbusiness bad debt loss, and a capital loss carryover

on their 1994 return.   Respondent determined that petitioners

were not entitled to the deductions.

                              OPINION

     In the notices of deficiency, respondent disallowed the

losses on the grounds that petitioners failed to establish the

amount of the debt and that it became uncollectible during the

1993 taxable year.   On brief, respondent argues that petitioner

did not prove that a true debtor-creditor relationship was
                                - 8 -


established between petitioner and Estes or substantiate the

amounts he transferred to Estes.    The evidence introduced at

trial by petitioner shows that he transferred the amounts at

issue to Estes.    Therefore, we do not consider this argument

further in deciding these cases.

     Respondent's determinations are presumed correct, and

petitioners bear the burden of proving otherwise.    See Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Petitioners must also prove their entitlement to any claimed

deduction.   Deductions are a matter of legislative grace, and

petitioners must show that their claimed deductions are allowed

by the Code.   See New Colonial Ice Co. v. Helvering, 292 U.S.

435, 440 (1934).

     Section 166(a) provides that a deduction shall be allowed

for any bad debt that becomes worthless within the taxable year.

Business bad debts are deductible as ordinary losses to the

extent of a taxpayer's adjusted basis in the debt.    See sec.

166(b).   Nonbusiness bad debts are treated as losses resulting

from the sale or exchange of a short-term capital asset.    See

sec. 166(d).

     To claim a bad debt deduction for the amounts advanced to

Estes, petitioner must prove that (1) a bona fide debt existed

between himself and Estes, and (2) the debt became wholly

worthless in 1993.    No deduction for partial worthlessness of a
                                - 9 -


nonbusiness debt is allowed.    See Black v. Commissioner, 52 T.C.

147, 151 (1969).

     A bona fide debt arises from a debtor-creditor relationship

where there is a valid and enforceable obligation to pay a fixed

or determinable sum of money.    See sec. 1.166-1(c), Income Tax

Regs.    No deduction may be taken for money advanced without a

reasonable expectation of repayment.    See Zimmerman v. United

States, 318 F.2d 611, 613 (9th Cir. 1963).    Thus, for this Court

to find that petitioner and Estes entered into a valid debtor-

creditor relationship, petitioner must show that the loans were

not contingent and that they were made with a reasonable

expectation, belief, and intention that the advances would be

repaid.    See id.

Contingent Debt

     Respondent contends that repayment of the advances was

contingent upon the success of the Theratech device.    Therefore,

respondent contends that these advances constitute contingent

loans.    Respondent argues that, because the Theratech device was

never financially successful, the requisite contingency never

occurred and the debts never became bona fide.    We disagree.

     Respondent confuses contingencies with risk.    A contingency

creates a condition precedent to the obligation to repay an

advance.    See Zimmerman v. United States, supra; Ewing v.

Commissioner, 20 T.C. 216 (1953), affd. 213 F.2d 438 (2d Cir.
                              - 10 -


1954).   The cases cited by respondent are clearly

distinguishable.   In Zimmerman v. United States, supra, the

taxpayers had advanced funds to a newly formed medical society.

The funds were advanced until such time as the organization was

financially stable and could repay a portion of the advance to

the taxpayer without jeopardizing its existence.     Given that

there was no evidence that the contingencies (financial stability

and ability to repay without jeopardy to the organization) ever

occurred, the Court of Appeals for the Ninth Circuit held that no

bona fide debt existed.    In Ewing v. Commissioner, supra, the

taxpayer advanced sums to a ballet company.   The company's

obligation to repay was expressly contingent on its having

operating profits.   Citing Clark v. Commissioner, 18 T.C. 780

(1952), affd. per curiam 205 F.2d 353 (2d Cir. 1953), this Court

noted that a debt does not arise where the obligation to repay is

subject to a contingency that has not occurred, and as the

contingency (operating profits) had not occurred, we found that

no debt was created.   See Ewing v. Commissioner, supra at 229.

     In the present case, there were no express or implicit

agreements between the parties that repayment was contingent upon

the financial success of the Theratech device.   Both petitioner

and Estes testified that Estes was obligated to repay the sums

advanced.   Furthermore, petitioner recovered as much of the debt

as possible.   Therefore, we conclude that petitioner's intentions
                              - 11 -


were not the same as those of the taxpayers in the above cases.

Accordingly, to the extent that we determine the advances in

these cases were loans, we do not find that the obligation to

repay was contingent upon the success of the Theratech device.

Instead we find that the obligation to repay the advances was

fixed; however, there was a sizable risk that Estes could not

repay the advances unless the device became a financial success.

Bona Fide Debt

     A determination that the obligation to repay is not

contingent on some future event does not necessarily mean that

the loans are bona fide debts for purposes of section 166.    It

must also be established by petitioners that the loans were made

with a reasonable expectation, belief, and intention that they

would be repaid.   The determination of whether a transfer was

made with a real expectation of repayment and an intention to

enforce the debt depends on all the facts and circumstances

including whether:   (1) There was a promissory note or other

evidence of indebtedness; (2) there is any written loan

agreement; (3) interest was charged; (4) there was security or

collateral, (5) there was a fixed maturity date; (6) a demand for

repayment was made; (7) any actual repayment was made; (8) the

transferee had the ability to repay; and (9) the parties'

records, if any, reflect the transaction as a loan.   See John
                              - 12 -


Kelley Co. v. Commissioner, 326 U.S. 521 (1946); Zimmerman v.

United States, supra.

     The key inquiry is not whether certain indicia of a bona

fide loan exist or do not exist, but whether the parties actually

intended and regarded the transaction as a loan.    See Estate of

Chism v. Commissioner, 322 F.2d 956, 959-960 (9th Cir. 1963),

affg. Chism Ice Cream Co. v. Commissioner, T.C. Memo. 1962-6;

Estate of Van Anda v. Commissioner, 12 T.C. 1158, 1163 (1949),

affd. per curiam 192 F.2d 391 (2d Cir. 1951).    Petitioner's

intent can be established from an examination of the facts

surrounding the transfers to Estes.    For the reasons listed

below, we find that petitioner had a reasonable expectation and

belief that he would be repaid for transfers he made to Estes up

to 1983, and that these transfers are bona fide loans.    Transfers

made after 1982, however, are not.

     Rather than foreclosing Estes' collateral upon the failure

of the gold-dredging operation, petitioner placed the stock in a

joint account.   As the inventor of the Theratech device, Estes

owned many more shares than the 100,000 shares in the account,

which had a value of approximately $1 per share at this time.

Therefore, although Estes considered himself to be in financial

trouble, he appeared to have financial resources and would be

able to repay the advances.   In addition, petitioner, who is an

experienced businessman, had used the Theratech device many times
                                - 13 -


and knew from experience that it produced the desired effect on

his hemorrhoids.     Thus, petitioner's belief at this time that

Estes would be able to repay and would repay the advances was

reasonable.

     However, soon after this time, the company manufacturing the

Theratech device encountered serious obstacles in marketing the

device.     Petitioner testified that because of these problems, the

stock traded for about 10 cents per share.     Petitioner knew that

Estes was dependent upon the financial success of the device and

the sale value of the Theratech stock to repay his debt.

     Although petitioner testified that he loaned Estes the

additional sums because he thought that he needed Estes to

promote the device, the problems with marketing were not related

to promotion.     According to petitioner's testimony, the marketing

problems were due to an FDA restriction, something over which

Estes had no influence.     We do not think that an experienced

businessman who was aware of Estes' financial situation after

1982 could have had a reasonable expectation or belief that Estes

would be able to repay greater indebtedness.     Accordingly, we

find that the advances made after 1982 did not create bona fide

debt.

Amount of the Bad Debt

        The evidence submitted at trial substantiated that

petitioner advanced Estes $271,231, $52,381 of which was to pay
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Estes' debt to the bank for his power boat.     Petitioners claimed

a deduction for a bad debt loss of $266,323 on their return for

1993.     Petitioner offered no explanation at trial for the

difference in these amounts; however, on brief petitioners stated

that the amount of the debt was reduced for the value of the

power boat that Estes transferred to petitioner in 1993.       We have

found that only the transfers made before 1983 created bona fide

debt.     Accordingly, we reduce the pre-1983 bad debt amount by the

value of the transferred power boat, which we find had a value of

no less than $41,000.

     Petitioner testified at trial that he placed the 100,000

shares of stock in a joint account with Estes, that he expected

Estes to repay him from the proceeds of the stock sales, and that

he and Estes sold the stock held in the joint account in small

amounts to maximize its value.     Evidence was introduced at trial

which shows that the stock was sold; however, petitioner made no

reduction in the debt for these sales.     Accordingly, we reduce

the amount of the pre-1983 bad debt for the sale proceeds of the

100,000 shares of Theratech stock that were placed in the joint

account.

Year of Worthlessness

        Petitioner asserts that the loans became worthless in 1993.

Respondent argues that there is no evidence with respect to

Estes' financial circumstances between 1993 and prior years that
                               - 15 -


establishes that the debt had value in 1993 and became worthless

in that same year.   We disagree.

     In ascertaining total worthlessness, the potential ability

to pay has a bearing, and we have no evidence that such potential

did not exist herein.    See Pierson v. Commissioner, 27 T.C. 330,

339 (1956), affd. 253 F.2d 928 (3d Cir. 1958).    Although Estes

appeared to become insolvent sometime before 1993, insolvency

would not show the debt was totally worthless.    See Roussel v.

Commissioner, 37 T.C. 235, 245 (1961).    An excess of liabilities

would show no more than that the debts of Estes were probably

uncollectible in part.    See Trinco Indus., Inc. v. Commissioner,

22 T.C. 959, 965 (1954).   It is clear that Estes had some assets,

as in 1993 he transferred to petitioner title to his boat, which

Estes testified was his only remaining asset.    After this

transfer, petitioner's attorney advised him that further

collection activity would be futile.    Accordingly, we find that

the debt became wholly worthless in 1993.

     To reflect the foregoing,

                                          Decisions will be entered

                                     under Rule 155.
