                        T.C. Memo. 2005-296



                      UNITED STATES TAX COURT



ESTATE OF WINIFRED HUGHES, DECEASED, DEAN McBRIDE, EXECUTOR AND
                     TRUSTEE, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21395-03.              Filed December 27, 2005.



     David S. Grossman, for petitioner.

     Julie L. Payne, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:   Respondent determined a deficiency of

$175,801 in the estate’s estate tax.

     Decedent’s husband, George Robert Hughes (Bob Hughes),

founded Bob Hughes Motors, Inc., d.b.a. Advance Leasing (Advance

Leasing).   Bob Hughes died in 1996.   Winifred Hughes (decedent)
                                - 2 -

was the sole owner of the stock of Advance Leasing from 1996

until she died in 1999.   After Bob Hughes died, Dean McBride

(McBride) became the sole officer and director of Advance

Leasing.   Decedent issued a durable power of attorney to McBride

in 1996.

     In 1997, McBride executed an agreement and a promissory note

on behalf of decedent and Advance Leasing which stated that

decedent promised to pay $400,000 to Advance Leasing on demand in

exchange for 4,000 shares of Advance Leasing’s common stock.

Advance Leasing issued a stock certificate to decedent for the

4,000 shares.   McBride paid the $400,000 to Advance Leasing after

decedent died in 1999.

     The issues for decision are:

     1.    Whether $400,000 is deductible under section

2053(a)(3)1 as a claim against decedent’s gross estate based on

the $400,000 promissory note.   We hold that it is not.

     2.    Whether interest of $21,782 owed to decedent by Advance

Leasing on certain promissory notes when decedent died is

included in decedent’s gross estate.    We hold that it is not.




     1
        Section references are to the Internal Revenue Code as in
effect as of the date of decedent’s death, unless stated
otherwise. Rule references are to the Tax Court Rules of
Practice and Procedure.
                                 - 3 -

                           FINDINGS OF FACT

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

A.   Dean McBride

     McBride, the executor of decedent’s estate, resided in

Phoenix, Arizona, when the petition was filed.       McBride was a

longtime friend of Bob Hughes and decedent.       Bob Hughes died on

April 10, 1996.     McBride was the executor of his estate.    McBride

became trustee or manager of the family trust and other entities

(discussed more fully below) that Bob Hughes and decedent

established to hold almost all of their property.

B.   Decedent and Bob Hughes

     Decedent and Bob Hughes were married around 1950 and lived

near Seattle, Washington for most of their lives.       They had two

children during their marriage:     Mark Hughes and Billy Hughes.

Decedent had another son, and Bob Hughes had two children from

prior marriages.     Decedent and Bob Hughes had 13 grandchildren.

Bob Hughes owned automobile dealerships for many years in Burien,

Washington, approximately 20 miles south of Seattle.

     On April 27, 1972, Bob Hughes and decedent established the

George R. Hughes Family Trust (GRH Trust) and other entities to

hold almost all of their property.       Bob Hughes was the trustee or

manager of GRH Trust and other entities that he and decedent had

established.   After Bob Hughes died on April 10, 1996, decedent

was the sole current beneficiary of GRH Trust, the children and
                                 - 4 -

grandchildren of Bob Hughes and decedent and certain charities

were future beneficiaries.     McBride became the trustee or manager

of GRH Trust and the other entities that Bob Hughes and decedent

had established.

     Decedent issued a durable power of attorney to McBride on

August 20, 1996.     At that time decedent was lucid and knew what

assets she owned and who her family members were.     Decedent moved

to an assisted living facility in Peoria, Arizona, on May 19,

1998.     She was soon diagnosed with Alzheimer’s disease.   She

lived there until she died on July 25, 1999.

C.   Advance Leasing

     1.     Organization and Operation

     Bob Hughes founded Advance Leasing around 1971.    He and

decedent originally owned all of the stock in Advance Leasing.

They transferred their stock to GRH Trust when they formed it in

1972.     Advance Leasing’s office was in Burien, Washington.

Advance Leasing sold used cars from 1971 through April 10, 1996.

It began buying cars to lease to third parties some time after

1971 but before April 10, 1996.

     Billy Hughes and Jeff Ross were independent contractors and

salespersons for Advance Leasing.     They earned commissions from

selling and leasing cars.     Bob Hughes hoped that Billy Hughes

would eventually own a car dealership.     Billy Hughes was a very

good salesman but had alcohol and drug problems.
                                 - 5 -

     Advance Leasing financed its purchases of cars with loans it

obtained from other entities established by Bob Hughes and

decedent.    At the end of 1994, 1995, and 1996, Advance Leasing

owed $755,640, $861,069, and $964,257, respectively, to Bob

Hughes and the other entities.

     When Bob Hughes died, decedent became the sole beneficial

owner of the stock of Advance Leasing, all of which was held by

GRH Trust.    Decedent was never involved in the business of

Advance Leasing.

     The Estate of Bob Hughes reported on the Federal estate tax

return that was filed on July 9, 1997, that the stock of Advance

Leasing had a fair market value of zero as of April 10, 1996, and

that its liabilities exceeded assets.    McBride signed that return

as executor for the Estate of Bob Hughes.

     2.     Advance Leasing’s Financial Statements for 1994-99

     Advance Leasing had the following amounts of gross sales,

cost of goods sold, operating income, expenses, and net loss for

1994-99:
                                               - 6 -
                               1994         1995          1996        1997          1998        1999

Gross sales--
  Used car retail sales        $94,553     $129,188      $64,350     $115,868      $68,416     $9,066
  Used car wholesale sales   1,100,376      999,448    1,318,741    1,846,700    1,100,987    107,153
                             1,194,929    1,128,636    1,383,091    1,962,568    1,169,403    116,219

Cost of goods sold--
  Used car retail sales        $91,873     $117,059      $66,400     $108,628      $64,449    $17,305
  Used car wholesale sales   1,008,774      883,066    1,208,813    1,649,438      997,423    108,348
  Reconditioning costs           2,897        --           --           --           --          --
                             1,103,544    1,000,125    1,275,213    1,758,066    1,061,872    125,653

Total operating income--
  Combined used car retail     $91,385     $128,511     $107,878     $204,502     $107,531    ($9,434)
    and wholesale sales
    income/(sales loss)
  Car lease income              43,699       40,122       40,747       34,553       27,099     15,447
  Capital gain income/          24,492        5,391       19,949          288       39,734       (647)
    (Capital loss)
  Dividend income                 --            290         --           --              4       --
  Interest income               13,380       12,229       19,675       34,180       33,732      1,051
  Miscellaneous income             550         --           --           --           --         --
  Other income                    --           --              74        --            550        267
  Other rental income             --          6,700        6,050        6,050        4,950       --
                               173,506      193,243      194,373      279,573      213,600      6,684

Total expenses                $240,178     $244,238     $234,899     $300,448     $214,846   $125,717

Net profit/(net loss)         ($66,672)    ($50,995)    ($40,526)    ($20,875)     ($1,246) ($119,033)

       Advance Leasing had the following amounts of assets,2

liabilities, capital, and net worth3 for 1994-99:

   Year Ended                                                                            Net
    Dec. 31              Assets           Liabilities               Capital             Worth

       1994             $447,310           $756,819              ($309,508)         ($309,508)
       1995              581,322            941,825               (360,503)          (360,503)
       1996              633,931          1,035,165               (401,234)          (401,234)
       1997              772,194          1,194,304               (422,110)          (422,110)
       1998              750,526          1,173,882               (423,356)          (423,356)
       1999              657,782            800,170               (142,388)          (142,388)




        2
        As discussed in par. E, below, Advance Leasing’s
financial statements for 1997 and 1998 did not refer to the 4,000
shares of Advance Leasing stock issued to decedent or decedent’s
$400,000 promissory note.
        3
            Net worth equals assets minus liabilities and capital (if
any).
                                         - 7 -

       Advance Leasing owed the following to Bob Hughes, George R.

Hughes Enterprise Limited Partnership (HELP),4 H & R Properties,5

and the Trust:
                                           Year ended Dec. 31
     Creditor        1994        1995       1996         1997         1998     1999

  Bob Hughes-
   Note payable        --      $10,000        --           --          --        --
   Accrued int.        --          350        --           --          --        --
      Total            --       10,350        --           --          --        --

  H & R Props.-
   Note payable    $755,640   $100,000    $100,000     $100,000     $100,000
$100,000
   Accrued int.        --        4,754        --          5,480       10,960
16,440
       Total        755,640    104,754     100,000      105,480      110,960
$116,440

  HELP-
   Note payable        --     $707,640    $782,640     $832,640     $782,640
$382,640
   Accrued int.        --       38,325      81,617      126,676      170,735
208,628
      Total            --      745,965     864,257      959,316      953,375
591,268

  Trust-
   Note payable        --         --          --           --        $50,000
$50,000
   Accrued int.        --         --          --           --          5,000
9,500
       Total           --         --          --           --         55,000
59,500

   Grand total     $755,640   $861,069    $964,257   $1,064,796   $1,119,335
$767,208

       Advance Leasing reported $29,663 of taxable income before

net operating loss deductions on its 1997 income tax return.

D.     HELP

       GRH Trust was a general partner of HELP.                 Children and

grandchildren of decedent and her husband were the limited

partners.        GRH Trust, as general partner, held a .581-percent

interest in HELP, and the children and grandchildren (the limited


        4
        George R. Hughes Enterprise Limited Partnership is
described in par. D, below.
        5
        H & R Properties was a Schedule C business owned by Bob
Hughes and decedent.
                               - 8 -

partners) held a 99.419-percent interest.   Advance Leasing

borrowed money from HELP, and owed HELP $953,375 by the end of

1998.

E.   The Stock Subscription Agreement and the $400,000 Promissory
     Note

     McBride knew it was important to decedent that Billy Hughes

always have a place to work.   On April 29, 1997: (1) McBride,

acting under a power of attorney from decedent and as president

of Advance Leasing, signed a stock subscription agreement under

which decedent agreed to pay Advance Leasing $400,000 on demand

and Advance Leasing agreed to issue to decedent an additional

4,000 shares of Advance Leasing’s common stock; and (2) Advance

Leasing issued a stock certificate to decedent for the 4,000

shares.   The terms of the stock subscription agreement were not

negotiated, and Advance Leasing’s business was not appraised.

The promissory note was not paid while decedent was alive.

     Neither the $400,000 promissory note nor the 4,000 shares

were identified on Advance Leasing’s 1997 and 1998 financial

statements or on its 1997 and 1998 corporate income tax returns.

Neither Advance Leasing’s bookkeeper nor its certified public

accountant, whose accounting firm had prepared Advance Leasing’s

tax returns and reviewed its financial statements since the early

1990s, knew about the stock subscription agreement or the

$400,000 promissory note.
                                - 9 -

F.   Events Following Decedent’s Death

     Decedent died on July 25, 1999.    McBride, as trustee of GRH

Trust, transferred $400,000 to Advance Leasing on September 20,

1999.    Advance Leasing had not previously demanded payment of the

promissory note.   During 1999, Advance Leasing used the $400,000

it received for the promissory note to repay $400,000 to HELP.

     In 1998, Billy Hughes’s wife filed for divorce, his

substance abuse problems worsened, and he stopped working for

Advance Leasing.   He entered a rehabilitation center for

treatment late in 1998.   Advance Leasing ceased operating around

2000.

G.   Decedent’s Estate Tax Return

     Decedent’s estate reported on the estate tax return that her

gross estate included $150,000 of principal Advance Leasing owed

on its notes to H & R Properties and GRH Trust, entities owned by

decedent, but did not include $21,782 of interest Advance Leasing

owed on those notes as of July 25, 1999, decedent’s date of

death.    Also on that return, decedent’s estate deducted $400,000

as a claim against the estate based on the $400,000 promissory

note.

     Decedent’s estate reported on that return that the stock of

Advance Leasing had no value on decedent’s date of death because

liabilities exceeded the fair market value of assets.   McBride

signed the return for decedent’s estate.
                                - 10 -

                                OPINION

A.   Whether $400,000 Is Deductible Under Section 6653(a)(1) as a
     Claim Against Decedent’s Gross Estate Based on the $400,000
     Promissory Note

     1.     Deductibility of Claims Against an Estate

     Tax may be imposed on the transfer of the taxable estate of

every decedent who is a citizen or resident of the United States.

Sec. 2001(a).     The decedent’s taxable estate is the value of the

decedent’s gross estate reduced by various deductions.      Sec.

2051.     One of those deductions is for claims against the estate

that are enforceable under State law.     Sec. 2053(a)(3); Propstra

v. United States, 680 F.2d 1248, 1254-1255 (9th Cir. 1982).

     An estate may deduct the value of a claim based on a

decedent’s promise to pay only if the liability was contracted

bona fide and for full and adequate consideration in money or

money’s worth.    Sec. 2053(c)(1)(A); Estate of Scholl v.

Commissioner, 88 T.C. 1265, 1279 (1987); Estate of Davis v.

Commissioner, 57 T.C. 833, 835 (1972).     This requirement prevents

an individual from reducing her or his taxable estate through

transactions that are in substance gifts.     Commissioner v.

Porter, 92 F.2d 426, 428 (2d Cir. 1937), affg. 34 B.T.A. 798

(1936).

     2.     The Estate’s Contentions

     The estate contends that the estate may deduct $400,000 on

the basis of its obligation to pay the promissory note.      The
                              - 11 -

estate contends that the note was the result of a bona fide

contract for full and adequate consideration in money or money’s

worth as required under section 2053(c)(1)(A).     The estate also

contends that decedent received full and adequate consideration

for her promise to pay Advance Leasing $400,000 because she

received 4,000 shares of stock in a corporation that appeared

ready to become profitable.

     The estate argues that by April 29, 1997, Advance Leasing

had experienced a dramatic turnaround.   The estate points out

that, in contrast to its losses for 1994, 1995, and 1996, Advance

Leasing reported $29,663 of taxable income before net operating

loss deductions on its 1997 income tax return.

     3.   Whether Decedent Received Full and Adequate
          Consideration for the Stock Subscription Agreement

     We first decide whether decedent’s receipt of 4,000 shares

of Advance Leasing stock on April 29, 1997, was full and adequate

consideration for her agreement to pay $400,000 to Advance

Leasing under the stock subscription agreement.6

     The estate contends the 4,000 shares of stock were adequate

consideration because Advance Leasing’s financial situation

improved dramatically from 1996 to 1997.   Advance Leasing

reported $29,663 of taxable income before net operating loss

     6
        The estate contends that the burden of proof in this case
is shifted to respondent under sec. 7491(a). We need not decide
that issue because we decide this case on the basis of the
preponderance of evidence without regard to the burden of proof.
                                - 12 -

deductions on its 1997 income tax return.   However, that return

is not consistent with its financial statements, which show a net

loss of $20,875 before net operating losses are considered.

     The estate contends the funds from the stock subscription

agreement reduced Advance Leasing’s debt obligations, made the

balance sheet cleaner, and made it easier for the company to

secure outside financing.   Despite this claim, Advance Leasing

did not receive the funds until after decedent died.

     Advance Leasing’s financial situation remained poor on April

29, 1997.   James McBride (an attorney for Advance Leasing and the

brother of McBride) testified that Advance Leasing and its

business had negligible, if any, value when the stock

subscription agreement was entered into on April 29, 1997.    James

McBride advised his brother regarding the stock subscription

transaction, and he drafted the stock subscription agreement and

the $400,000 promissory note.    James McBride stated that it would

have been futile for HELP to demand full payment by Advance

Leasing because Advance Leasing lacked the ability to repay the

more than $864,000 it owed to HELP at the end of 1996.   James

McBride testified that HELP wanted Advance Leasing to survive in

the hope that it would generate income and repay its debt to

HELP.

     James McBride’s testimony is corroborated by the estate tax

return for the Estate of Bob Hughes and the Advance Leasing
                                  - 13 -

financial statements.      According to the estate tax return for the

Estate of Bob Hughes, the stock of Advance Leasing had a fair

market value of zero as of April 10, 1996.      Advance Leasing had

net losses of $66,672 for 1994, $50,995 for 1995, and $40,526 for

1996.       Even taking into account decedent’s $400,000 note, Advance

Leasing had a negative total net worth of $22,110 at the end of

1997 and $23,356 at the end of 1998.7

     Advance Leasing used the entire $400,000 it received in 1999

from decedent to repay some of the more than $900,000 it then

owed to HELP.      Thus, the $400,000 payment to HELP directly

benefited decedent’s children and grandchildren.

     We do not believe that the value of Advance Leasing’s stock

increased from zero on April 10, 1996 (as reported on the estate

tax return for Bob Hughes which McBride signed) to $400,000 on

April 29, 1997, and then fell to zero on July 25, 1999 (the date

decedent died, as reported on decedent’s estate tax return also

signed by McBride).      We conclude that the 4,000 shares issued to

decedent had little or no value when McBride signed the stock

subscription agreement on April 29, 1997.8      Thus, decedent did not

receive full and adequate consideration as required by section

        7
        As discussed supra, Advance Leasing’s 1997 and 1998
financial statements did not reflect the additional 4,000 shares
issued to decedent and the $400,000 stock subscription agreement
note payable to Advance Leasing.
        8
        Neither party offered expert testimony on the value of
Advance Leasing stock on Apr. 29, 1997.
                               - 14 -

2053(c)(1)(A) for the $400,000 she agreed to pay Advance Leasing

in exchange for the 4,000 additional shares.

     4.     Whether the Stock Subscription Transaction Was
            Contracted Bona Fide

     The estate contends that the $400,000 stock subscription

agreement (the agreement to pay $400,000 in exchange for 4,000

shares of Advance Leasing common stock) was contracted bona fide.

We disagree.

     “Contracted bona fide” means made in good faith and

bargained for at arm’s length.    Secs. 20.2043-1(a), 20.2053-4,

Estate Tax Regs.; see Bank of New York v. United States, 526 F.2d

1012, 1015 (3d Cir. 1975); Estate of Morse v. Commissioner, 69

T.C. 408, 418 (1997), affd. 625 F.2d 133 (6th Cir. 1980).    When

family members adopt a course of action with the intent to pass

on wealth, a deduction for the amount transferred is not

permitted under section 2053 unless there was a bargained-for

exchange.    Estate of Huntington v. Commissioner, 16 F.3d 462, 467

(1st Cir. 1994), affg. 100 T.C. 313 (1993).    McBride was

decedent’s attorney in fact and Advance Leasing’s sole director

and officer; thus, he was on both sides of the stock subscription

transaction.    That transaction must be subjected to enhanced

scrutiny.    See Bank of New York v. United States, supra at 1016-

1017; Estate of Woody v. Commissioner, 36 T.C. 900, 903 (1961).

     The estate contends that the stock subscription agreement

was bona fide because:    (1) Decedent wanted Advance Leasing to
                               - 15 -

continue to operate so that Billy Hughes would have a place to

work; (2) McBride conducted business in the same way that Bob

Hughes did; (3) owners of small businesses typically operate

other than at arm’s length; and (4) James McBride advised McBride

about fiduciary obligations.

     Those points do not convince us that the stock subscription

agreement was bona fide.   McBride’s engaging in conduct similar

to that of Bob Hughes does not show that the stock subscription

agreement was at arm’s length or bona fide without a showing that

Bob Hughes always acted at arm’s length when dealing with his

related entities.   In addition, whether or not the related

entities dealt with each other at arm’s length, section

2053(c)(1)(A) provides that the estate is not allowed a deduction

in this case unless the claim against the estate was contracted

bona fide and for adequate and full consideration.   We have no

reason to question McBride’s intent to act properly or the

quality of the legal advice he received; however, that does not

determine whether the stock subscription was at arm’s length.

     The following facts show that the stock subscription

agreement, made on April 29, 1997, was not bona fide:   (1) The

terms of the stock subscription agreement were not negotiated at

arm’s length; (2) Advance Leasing’s business was not appraised,

and Advance Leasing had annual net losses and a negative net

worth in 1996, 1997, and 1998 both before and after the April 29,
                              - 16 -

1997, stock subscription transaction; (3) the 4,000 shares and

the $400,000 demand note payable to Advance Leasing were not

reflected on Advance Leasing’s 1997 and 1998 financial statements

or on its 1997 and 1998 tax returns; (4) Advance Leasing’s

bookkeeper and its certified public accountant did not know about

the stock subscription agreement and the $400,000 note payable,

and (5) Advance Leasing and McBride (its sole officer and

director) did not demand payment of the $400,000 before August

20, 1999.

     After decedent died, Advance Leasing received and used the

proceeds to repay $400,000 to HELP, the family partnership in

which certain children and grandchildren of decedent and

decedent’s husband collectively held a 99.419-percent interest.

Considering all the circumstances, we conclude that the stock

subscription agreement was a substitute for a testamentary

disposition to decedent’s children and grandchildren.9




     9
        The estate contends that we should not treat the $400,000
payment as a testamentary disposition because, if decedent had so
intended, she could have reduced her estate by $140,000 per year
by giving $10,000 to each of her 14 children and grandchildren
each year. Regardless of how decedent might have done things
differently, we evaluate the facts before us. See Commissioner
v. Natl. Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148-149
(1974).
                                 - 17 -

     5.    Conclusion

     We conclude that the estate may not deduct $400,000 from

decedent’s gross estate as a claim against her estate under

section 2053(a)(3) based on the $400,000 promissory note.10

B.   Whether Decedent’s Gross Estate Includes $21,782 of Accrued
     Interest Owed by Advance Leasing on Certain Notes

     Decedent’s estate included in the gross estate $150,000

representing the principal amount that Advance Leasing owed on

its notes to H & R Properties and the Trust.       However, the estate

did not include in the gross estate $21,782 representing accrued

interest that Advance Leasing owed on those notes when decedent

died.11

     The gross estate includes the value, at the time of death,

of all property in which decedent had an interest.      Secs.

2031(a), 2033.   The $21,872 of accrued interest is included in

decedent’s gross estate to the extent that it had value at the

time of her death.      See secs. 2031(a), 2033.

     Fair market value is “‘the price at which the property would

change hands between a willing buyer and a willing seller,

neither being under any compulsion to buy or to sell and both


      10
        In light of this holding, we need not decide
respondent’s other arguments that the note was not bona fide or
enforceable against decedent’s estate under Washington law or
that decedent lacked competence to execute the power of attorney.
      11
       The estate did not elect the alternate valuation date
under sec. 2032.
                              - 18 -

having reasonable knowledge of relevant facts.’”    United States

v. Cartwright, 411 U.S. 546, 551 (1973) (quoting section

20.2031-1(b), Estate Tax Regs.).    The fair market value of a note

is generally the amount of the unpaid principal, plus interest

accrued to the date of a decedent’s death, unless the executor

establishes that the value is lower or that the note is

worthless.   Sec. 20.2031-4, Estate Tax Regs.   The fair market

value of the accrued interest is the amount of unpaid accrued

interest as of the date of decedent’s death unless the executor

establishes a lower value.   See id.

     Respondent contends that decedent’s estate includes $21,782

of accrued interest owed by Advance Leasing because:    (1) Advance

Leasing could have used the $400,000 to pay $21,782 of accrued

interest; or (2) decedent could have reduced the $400,000 owed

under the stock subscription agreement note against the $21,782.

We disagree.   We believe that the fair market value of the

accrued interest is zero because:    (1) Advance Leasing was

insolvent;12 and (2) we do not believe that a willing buyer with

knowledge of Advance Leasing’s financial situation would pay any

amount for the $21,872 of accrued interest owed by Advance

Leasing.   We conclude that the $21,782 of accrued interest had no



     12
        Respondent acknowledges that Advance Leasing was
insolvent and that its liabilities exceeded its assets during
1999.
                             - 19 -

value on the date of decedent’s death and is not included in her

gross estate.

     To reflect the foregoing,


                                             Decision will be

                                        entered under Rule 155.
