                  T.C. Memo. 2006-78



                UNITED STATES TAX COURT



          SID PAUL RUCKRIEGEL, Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent

            AL A. RUCKRIEGEL, Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos. 21675-03, 21676-03.        Filed April 18, 2006.



     Ps were each 50-percent shareholders in an S
corporation that incurred ordinary losses before and
during the years in question (1999 and 2000). They
were also 50-percent partners in a partnership that
advanced funds, both directly and indirectly (through
Ps) to the S corporation in 1997-2000. The issue for
decision is whether all or a portion of those advances
resulted in loans from the partnership to Ps and from
Ps to the S corporation, thereby providing Ps with
sufficient bases in the S corporation, under sec.
1366(d)(1)(B), I.R.C., to permit each P to deduct his
50-percent share of that corporation’s ordinary losses
for the years in question.

     Held: Only the partnership advances through Ps
resulted in loans from the partnership to Ps and from
Ps to the S corporation, and those advances provided Ps
with sufficient bases in the S corporation to deduct
                                  - 2 -

     only a small portion of that corporation’s 1999
     ordinary loss and none of its 2000 ordinary loss.



     Scott W. Dolson and Robert C. Webb, for petitioners.

     Denise A. Diloreto and Mark D. Eblen, for respondent.



                 MEMORANDUM FINDINGS OF FACT AND OPINION


     HALPERN, Judge:      These consolidated cases involve the

following determinations by respondent of deficiencies in

petitioners’ Federal income tax:

          Year              Al A. Ruckriegel    Sid Paul Ruckriegel
          1999                  $110,544              $107,064
          2000                   122,272               124,130

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.   All dollar amounts have been rounded to the nearest

dollar.

     The issue for decision is whether petitioners had sufficient

bases in their S corporation,1 Sidal Inc. (Sidal), during 1999

and 2000 (the audit years), under section 1366(d)(1)(B), to


     1
        The term “S corporation” is defined in sec. 1361(a)(1).
In general, an S corporation has no Federal income tax liability,
and its items of income, deduction, credit, and such are passed
through to (i.e., taken into account by) its shareholders. See
secs. 1363(a), 1366(a).
                                 - 3 -

permit each of them to deduct his pro rata share of Sidal’s

ordinary losses, to the extent of $329,7972 for 1999 and $492,588

for 2000 (sometimes, the basis issue).3

     The notices of deficiency contain certain other adjustments

that are purely computational.    Their resolution solely depends

upon our resolution of the basis issue.




     2
        The parties stipulate that Sid Paul Ruckriegel’s (Sid’s)
1999 deduction for Sidal’s 1999 losses was $324,750, but Sid’s
1999 return confirms that he reported a 1999 loss of $329,797
from Sidal. That is also the amount of the Sidal loss respondent
disallowed in the notice of deficiency issued to Sid. Erroneous
stipulations are not binding on this Court. See Gulf Oil Corp.
v. Commissioner, 87 T.C. 135, 159-160 n.4 (1986), affd. 914 F.2d
396 (3d Cir. 1990). Therefore, we find that Sid’s 1999 reported
loss from Sidal is $329,797.
     3
        In his notices of deficiency, respondent also made
adjustments, pursuant to sec. 267(a)(2), increasing each
petitioner’s “passthrough” income from Sidal by $12,407 for 1999
and $37,233 for 2000 attributable to Sidal’s disallowed
deductions for interest owed to a related party. Respondent
characterizes the adjustments, both on brief and in his notices
of deficiency, as increases in each petitioner’s interest income
from Sidal. Although petitioners assign error to those
adjustments in their petitions, they make no argument either in
their trial memoranda or on brief concerning the adjustments.
Consequently, we consider the adjustments to have been conceded
by petitioners. See Nicklaus v. Commissioner, 117 T.C. 117, 120
n.4 (2001); Rybak v. Commissioner, 91 T.C. 524, 566 n.19 (1988);
Zimmerman v. Commissioner, 67 T.C. 94, 104 n.7 (1976).
                                - 4 -

                        FINDINGS OF FACT4

     Some facts have been stipulated and are so found.    The

stipulation of facts, with attached exhibits, is incorporated by

this reference.

     At the time the petitions were filed, petitioner Sid Paul

Ruckriegel (Sid) resided in Peoria, Illinois, and petitioner Al

A. Ruckriegel (Al) resided in Terre Haute, Indiana.

Sidal, Inc.

     Sidal, an Indiana corporation, elected S corporation status

at the time of its organization in 1993 and retained that status

through December 31, 2000.   During that period, petitioners were

each 50-percent shareholders in Sidal.   Sidal operated

approximately 50 fast food franchise restaurants throughout

Indiana and part of Illinois during the 1997-2000 period.    From

its incorporation in 1993 through 2000, Sidal operated at a loss.

Sid and Al actively managed the Sidal restaurants.

Paulan Properties Partnership

     From its formation, in 1993, through December 31, 2000,

petitioners were each 50-percent partners of Paulan Properties

Partnership (Paulan), a general partnership governed by Indiana


     4
        To the extent that petitioners fail to object to
respondent’s proposed findings of fact, or vice versa, we
conclude that those proposed findings of fact are correct except
to the extent that the nonobjecting party’s proposed findings of
fact are clearly inconsistent therewith. See Jonson v.
Commissioner, 118 T.C. 106, 108 n.4 (2002), affd. 353 F.3d 1181
(10th Cir. 2003).
                                   - 5 -

law.       Paulan owns real property and leases it to several of the

restaurants operated by Sidal, as well as to other restaurant

operators.       Petitioners managed Paulan’s properties.   From 1997

through 2000, Paulan operated at a profit.

Other Individuals and Entities Related to Paulan and Sidal

       Lovella Ruckriegel (Lovella) and Robert Ruckriegel (Robert)

are petitioners’ parents.       Pursuant to the Paulan partnership

agreement, control and management of Paulan were vested in

Lovella.       As a practical matter, however, Lovella’s duties

consisted of receiving, depositing, and recording incoming cash

and writing and recording checks on Paulan’s behalf.

       Robert and Lovella own the controlling interest in BR

Associates, Inc., which provides financial advice, bookkeeping,

secretarial, and administrative services to Paulan and Sidal.

Larry Freyberger (Freyberger) works for BR Associates, Inc., with

the title of controller, and he maintains Sidal’s general ledger.

His services on behalf of Paulan consist of receiving the check

register from Lovella and computerizing the transactions recorded

therein, using previously assigned account numbers.         He and his

staff provide general bookkeeping services for Sidal and

provide a trial balance5 to an outside certified public

accountant (C.P.A.) at yearend.


       5
        A trial balance (or adjusted trial balance) is a record
taken from the books of account. See Cooper & Ijiri, Kohler’s
Dictionary for Accountants 24, 514 (6th ed. 1983).
                               - 6 -

     Ralph Michel (Michel) was the outside C.P.A., and he

prepared tax returns for Paulan and Sidal for 1997, 1998, and

2000 and for petitioners for 1997-2000.    He has been the

principal tax adviser to petitioners since 1976 and to Paulan and

Sidal since their formation in 1993.    Ernst & Young (EY) prepared

and compiled financial statements for Paulan and Sidal and

prepared tax returns for those entities for 1999.    EY did not

audit the books of either entity.

Prior Audits and Tax Planning Discussions Between Michel and
Petitioners

     Respondent audited petitioners’ 1995 and 1996 returns.    A

result of that audit was the denial of petitioners’ deductions of

Sidal’s 1995 and 1996 losses on the ground that petitioners

lacked bases in Sidal.   Petitioners paid the deficiencies

relating to the denial of those deductions.    After that audit,

Michel spoke with the Internal Revenue Service (IRS) agent who

conducted the audit regarding the proper way to structure future

loans to Sidal so as to enable petitioners to achieve bases in

Sidal equal to the loan amounts.    In 1997, after that

conversation, Michel advised petitioners that loans to Sidal

could be structured to obtain tax bases for them in Sidal, and he

advised them regarding that structure.    The 1997-2000 loans to

Sidal were structured in accordance with Michel’s advice.    The

IRS agent auditing petitioners’ 1997 and 1998 tax years did not

challenge petitioners’ passthrough deductions of Sidal’s losses
                                - 7 -

to the extent of petitioners’ bases in Sidal attributable to (1)

$1 million wire transfers from Paulan to each petitioner and from

each petitioner to Sidal on November 24, 1997 (the wire transfer

payments), and (2) a $200,000 capital contribution by each

petitioner to Sidal on July 11, 1997.

Description of the Loans

       On 11 occasions during the 1997-2000 period, Paulan

transferred funds directly or indirectly (via the wire transfer

payments) to Sidal.6   The bank loans that constituted the source

of the funds, the transactions themselves, and the manner in

which they were reflected in the financial statements of Paulan

and Sidal are described as follows.

1997

       Paulan Bank Borrowings

       July 10 - $3,550,550.00 ($3.6 million less $49,450.00 in

closing costs) from the Merchants Bank of Terre Haute, Indiana

(Merchants Bank) (the $3.6 million Merchants Bank loan).


       6
        On their individual returns for 1997, petitioners each
claimed a debt basis of $1 million in Sidal attributable to the
wire transfer payments, and they deducted suspended Sidal losses
from prior years. As noted in the text, respondent did not
challenge those deductions. The amounts of basis attributable to
those payments that carried over to 1999 are not certain. A
basis schedule for 1993-99, prepared by Michel, indicates a
remaining 1999 basis from those payments of $5,065 for each
petitioner, but petitioners’ 1999 returns indicate a remaining
basis of $5,064 for Al and $34,554 for Sid. As discussed infra,
respondent denies the existence of any post-1998 carryover basis
under sec. 1366(d)(1)(B) attributable to the wire transfer
payments.
                                - 8 -

     July 10 - $1 million in the form of a revolving loan line of

credit arrangement with Merchants Bank (the $1 million Merchants

Bank loan).

     Both the $3.6 million and the $1 million Merchants Bank

loans were secured by assets of both Paulan and Sidal and

guaranteed by Sidal, Robert, Lovella, and petitioners.

     December 8 - $2 million from Merchants Bank (the $2 million

Merchants Bank loan), secured by life insurance policies,

securities, and Paulan real and personal property, and also

guaranteed by Sidal, Robert, Lovella, and petitioners.

     Paulan Payments

     The July 11 Payment

     On July 11, Paulan wrote a check to Sidal for $1.2 million.

The source of that payment was the $3.6 million Merchants Bank

loan.    Sidal’s adjusted trial balances for its taxable years

ending December 31, 1997, 1998, 1999, and 2000, reflect the $1.2

million payment to it as giving rise to a note payable to Paulan.

Correspondingly, Paulan’s adjusted trial balances for its taxable

years ending December 31, 1997 and 1998, reflect the $1.2 million

payment to Sidal as giving rise to a note receivable from Sidal.7

Sidal made principal and interest payments to Paulan on that note

of $74,328 in 1997, $178,388 in 1998, $148,657 in 1999, and



     7
        Paulan’s adjusted trial balances for its taxable years
ending Dec. 31, 1999 and 2000, are not in evidence.
                                 - 9 -

$193,253 in 2000.    No adjusting journal entries were made on any

of the above-mentioned Paulan and Sidal trial balances to

recharacterize either Paulan’s July 11 payment to Sidal or any of

the principal and interest payments by Sidal to Paulan as

consistent with, first, loans by Paulan to petitioners and, then,

loans by petitioners to Sidal.

     The November 24 Wire Transfer Payments

     The source of the wire transfer payments is not clear from

the record.8   All of the Paulan and Sidal adjusted trial balances

in evidence, beginning with the adjusted trial balances for the

taxable year ending December 31, 1997, reflect the wire transfer

payments as $1 million loans from Paulan to each petitioner and

from each petitioner to Sidal.    Sidal made principal and interest

payments directly to Paulan in connection with the wire transfer

payments totaling $276,518 in 1998, $230,431 in 1999, and

$299,561 in 2000.9




     8
        The parties stipulated that the source of the wire
transfer payments were the $2 million Merchants Bank loan, which
occurred on Dec. 8, 1997, 2 weeks after the wire transfer
payments.
     9
        As noted, petitioners’ claims of basis in Sidal, under
sec. 1366(d)(1)(B), attributable to the wire transfer payments
were not challenged by respondent in connection with the audit of
petitioners’ 1997 and 1998 returns.
                               - 10 -

1998

       During 1998, Paulan wrote four checks to Sidal as follows:

              Jan. 20              $100,000
              Feb. 17               200,000
              Aug. 25                18,000
              Oct. 27               650,000
               Total                968,000

The source of those payments was the $1 million Merchants Bank

loan.

       Sidal’s adjusted trial balances for the taxable years ending

December 31, 1998, 1999, and 2000, reflect a note payable to

Paulan in the sum of $928,000,10 and Paulan’s adjusted trial

balance for the taxable year ending December 31, 1998, reflects a

corresponding note receivable from Sidal.     No adjusting entries

were made on those trial balances to recharacterize Paulan’s 1998

payments to Sidal, to the extent of $928,000, as Paulan’s loans

to petitioners and petitioners’ loans to Sidal.11    Handwritten



       10
        There is no explanation in the record for the
discrepancy between the total amount of the 1998 Paulan checks,
$968,000, and the $928,000 note payable from Sidal to Paulan
reflected on Sidal’s adjusted trial balances.
       11
        Although (1) a handwritten entry on Sidal’s adjusted
trial balance for its taxable year ending Dec. 31, 1999,
indicates that the $928,000 note payable to Paulan was “reclassed
by AJEs” (adjusting journal entries) and (2) Sidal’s general
ledger for 1999 reflects the elimination, on Oct. 19, 1999, of
$928,000 as an intercompany note to Paulan, Sidal’s adjusted
trial balance for the following year (2000) still reflects the
$928,000 as a note payable to Paulan as of Dec. 31, 2000.
                               - 11 -

entries on Sidal’s adjusted trial balance for its taxable year

ending December 31, 2000, show 2000 principal and interest

payments on those loans of $67,213 and $111,175, respectively.

1999

       On April 20, 1999, Paulan borrowed $250,000 from Bavaria,

Inc., a C corporation, the stock of which is wholly owned by

Robert and Lovella.    On December 31, 1999, Paulan used the

proceeds of that loan to write a check to Sidal for $250,000.

       On November 12, 1999, Paulan borrowed $525,000 from Civitas

Bank.    That loan was secured by certain marketable securities and

guaranteed by Robert and Lovella.    On November 17, 1999, Paulan

used the proceeds of that loan to write a check to Sidal for

$525,000.

       Although both Paulan’s and Sidal’s general ledgers for 1999

reflect the two advances as resulting in a $775,000 payable from

Sidal to Paulan, adjusting entries were made on both entities’

adjusted trial balances for the taxable year ending December 31,

1999, to change the $775,000 from a note payable by Sidal to

Paulan to notes for $125,000 and $262,500 payable by Sidal to

each petitioner and receivables by Paulan from each petitioner.
                               - 12 -

2000

       On May 11, 2000, Paulan borrowed $1,350,000 from Old

National Bank (formerly Merchants Bank).12    The loan was secured,

in part, by Paulan real property and guaranteed by Robert,

Lovella, and petitioners.   The loan was the source of the

following three Paulan checks to Sidal written in 2000:

              Jan. 21                $200,000
              Mar. 28                   500,000
              Oct. 5                    400,000
               Total                1,100,000

       Although Sidal’s adjusted trial balance for its taxable year

ending December 31, 2000, originally reflected a note payable to

Paulan for $1.1 million, adjusting entries were made, as of

December 31, 2000, to reflect, instead, notes payable to

petitioners for $550,000 each.

The Promissory Notes

       Sometime during the years 1997-2000, petitioners each

executed promissory notes to Paulan, and Sidal executed

promissory notes to each petitioner (collectively, the promissory




       12
        Paulan applied for, and Old National Bank approved, a
$1,750,000 loan. There is no explanation in the record for the
$400,000 discrepancy between the loan applied for and approved
and the actual amount of the loan.
                               - 13 -

notes), bearing the following dates of execution and in the

following amounts:13

                 Sid to         Sidal        Al to       Paulan
    Date         Paulan        to Sid       Paulan       to Sid

   6/30/97      $600,000      $600,000      $600,000     $600,000
  12/18/97     1,000,000      1,000,000    1,000,000    1,000,000
  10/31/98       464,000        464,000      464,000      464,000
   4/20/99       125,000        125,000      125,000      125,000
  11/12/99       262,500        262,500      262,500      262,500
   1/31/00       100,000        100,000      100,000      100,000
   3/31/00       250,000        250,000      250,000      250,000
  10/31/00       200,000        200,000      200,000      200,000


     The June 30, 1997, promissory notes predate the transaction

to which they relate; i.e., Paulan’s July 11, 1997, check to

Sidal for $1.2 million.    Similarly, the April 20 and November 12,

1999, promissory notes predate the transactions to which they

relate; i.e., Paulan’s December 31 and November 17, 1999, checks

to Sidal for $250,000 and $525,000 respectively.14

     13
        Thus, for each alleged effective date, there were four
promissory notes (one each by Sid and Al to Paulan, and two by
Sidal, one each to Sid and Al) in matching amounts. With the
exception of the notes dated Dec. 18, 1997, which correspond to
the $1 million wire transfer payments, and the notes dated Oct.
31, 1998, each promissory note represents one-half of the amount
of a check from Paulan to Sidal. The notes dated Oct. 31, 1998,
each represent one-half of $928,000.
     14
        The Apr. 20 and Nov. 12, 1999, promissory notes bear
effective dates and amounts corresponding to Paulan’s borrowings
                                                   (continued...)
                              - 14 -

Directors and Partners’ Minutes

     Sidal

     For each Sidal promissory note, petitioners, in their

capacities as the directors of Sidal, executed minutes of a

“Special Meeting of the Board of Directors of Sidal, Inc.”, which

purported to be the minutes of a board of directors meeting to

authorize (1) the borrowing from each petitioner and (2) the

promissory note to each petitioner.    In each case, the specified

date of the board of directors meeting was the effective date

appearing on the corresponding promissory notes.

     Paulan

     Petitioners, in their capacities as the sole general

partners of Paulan, executed “Minutes of the Special Meeting of

the Partners of Paulan Properties” specifically authorizing the

following loans: (1) the wire transfer payments reflected in the

promissory notes of $1 million from each petitioner to Paulan,

dated December 18, 1997, (2) the $250,000 check to Sidal, dated

December 31, 1999, reflected in the promissory notes of $125,000

from each petitioner to Paulan, dated April 20, 1999, and (3) the

$525,000 check to Sidal, dated November 17, 1999, reflected in

the promissory notes of $262,500 from each petitioner dated

November 12, 1999.   The partners’ minutes authorizing those three



     14
      (...continued)
of $250,000 on Apr. 20, 1999, and $525,000 on Nov. 12, 1999.
                              - 15 -

loans to petitioners reflect meeting dates of December 18, 1997,

April 20, 1999, and November 12, 1999, the dates of petitioners’

promissory notes.

     Petitioners also executed partners minutes reflecting an

April 1, 1997, meeting of the Paulan partners (a date prior to

any of the Paulan bank borrowings or advances to Sidal or

petitioners).   Those minutes, in effect, provide advance

authorization for any future Paulan loans to petitioners for the

purpose of enabling them to relend the funds to Sidal and for

those loans to take the form of direct payments to Sidal.

     None of the Sidal or Paulan minutes described herein

(collectively, the minutes) were drafted and executed earlier

than June 2000, and the minutes describing an October 31, 2000,

Sidal board of directors meeting were drafted and executed

sometime after October 31, 2000.

Stock Basis

      Petitioners’ adjusted tax bases in their Sidal stock were

zero as of January 1, 1999, 2000, and 2001.

                              OPINION

I.   Introduction

      Respondent disallowed each petitioner’s deduction of his 50-

percent share of Sidal’s ordinary losses for 1999 and 2000 on the

ground that petitioners had zero bases for their respective

investments in Sidal.   Each petitioner’s basis in Sidal depends
                                 - 16 -

on the characterization properly attaching to certain payments

originating with Paulan, a partnership, and ultimately received

by Sidal, an S corporation.      Those payments were made on various

dates beginning in 1997 and ending in 2000 (the 1997-2000

payments).    In all but one instance, the 1997-2000 payments were

made directly by Paulan to Sidal (the Paulan direct payments).

In that one instance (the wire transfer payments), payment by

Paulan was made indirectly, through petitioners to Sidal.       The

Paulan direct payments totaled $4,043,000, and the wire transfer

payments totaled $2 million.      We must determine the extent, if

any, to which the 1997-2000 payments provided petitioners with

bases in Sidal.

II.   Burden of Proof

      A.    Section 7491

      In general, the taxpayer bears the burden of proving that

the Commissioner’s determinations in the deficiency notice are in

error.     See Rule 142(a)(1).   Section 7491(a)(1) provides,

however, that “[i]f * * * a taxpayer introduces credible evidence

with respect to any factual issue relevant to ascertaining * * *

[the taxpayer’s proper tax liability]”, the burden of proof with

respect to that issue shall be on the Commissioner.      See also

Rule 142(a)(2).     Credible evidence is evidence the Court would

find sufficient upon which to base a decision on the issue in

favor of the taxpayer if no contrary evidence were submitted.
                                - 17 -

See Higbee v. Commissioner, 116 T.C. 438, 442 (2001); Bernardo v.

Commissioner, T.C. Memo. 2004-199 n.6.     Section 7491(a)(1)

applies only if the taxpayer complies with any substantiation

requirements imposed by the Internal Revenue Code, maintains all

required records, and cooperates with the Commissioner for

witnesses, information, documents, meetings, and interviews.

Sec. 7491(a)(2)(A) and (B).     The taxpayer bears the burden of

proving compliance with the conditions of section 7491(a)(2)(A)

and (B).     H. Conf. Rept. 105-599, at 240 (1998), 1998-3 C.B. 747,

994.

       B.   Arguments of the Parties

       Petitioners argue that the burden of proof with respect to

the basis issue shifts to respondent because they complied with

all of the conditions of section 7491(a)(2) and presented

credible evidence of sufficient bases in Sidal to sustain their

passthrough deductions for the audit years. Although respondent

concedes that petitioners complied with the record maintenance

and cooperation requirements of section 7491(a)(2)(B), he argues

that petitioners did not comply with the substantiation

requirement of section 7491(a)(2)(A), and that, therefore, the

burden of proof on the basis issue remains with petitioners.

Respondent also argues that petitioners failed to introduce

credible evidence of their bases in Sidal during the audit years.
                                 - 18 -

     C.   Analysis

             1.   The Paulan Direct Payments

     For reasons discussed infra, we agree with respondent that

petitioners have failed to introduce credible evidence that the

Paulan direct payments provided them with bases in Sidal during

the audit years.     Therefore, it is unnecessary to address the

issue of petitioners’ compliance with the requirement of section

7491(a)(2)(A) “to substantiate any item” as it may apply to those

payments.

     Because we find that petitioners have failed to introduce

credible evidence that the Paulan direct payments provided

petitioners with basis in Sidal, we decide the basis issue as it

relates to those payments in respondent’s favor; i.e., the

absence of credible evidence that petitioners acquired bases in

Sidal by virtue of the Paulan direct payments necessarily means

that petitioners cannot sustain their resulting burden of proof

with respect to those payments.     See Bernardo v. Commissioner,

supra n.7.

             2.   The Wire Transfer Payments

     Because we base our decision (discussed infra) regarding

petitioners’ bases in Sidal attributable to the wire transfer

payments upon a preponderance of the evidence, assignment of the

burden of proof under section 7491 is unnecessary.     See FRGC

Inv., LLC v. Commissioner, T.C. Memo. 2002-276, affd. on this
                                - 19 -

issue 89 Fed. Appx. 656 (9th Cir. 2004); Polack v. Commissioner,

T.C. Memo. 2002-145 n.7, affd. on this issue 366 F.3d 608, 613

(8th Cir. 2004).

III.    Petitioners’ Bases With Respect to Sidal

       A.   Principal Statutory Provisions

       Section 1366(a)(1) provides that a shareholder of an S

corporation shall take into account his pro rata share of the S

corporation’s items of income, loss, deduction, or credit for the

S corporation’s taxable year ending with or in the shareholder’s

taxable year.     Section 1366(d)(1), however, limits the amount of

such losses and deductions (without distinction, losses) that a

shareholder may take into account for any taxable year to an

aggregate amount not exceeding the sum of (1) his adjusted basis

in the stock of the S corporation and (2) his adjusted basis in

any indebtedness of the S corporation to the shareholder.    Any

losses so disallowed may be carried forward indefinitely.    See

sec. 1366(d)(2).

       B.   Summary of the Parties’ Arguments

       Petitioners contend that all of the 1997-2000 payments

were, in substance, direct loans from them (one-half each) to

Sidal that increased their debt bases in Sidal, under section

1366(d)(1)(B), by an amount sufficient to sustain the deductions

for Sidal’s operating losses reported on their returns for the

audit years.     Respondent contends that all of those payments were
                                - 20 -

interentity loans from Paulan to Sidal that did not increase

petitioners’ debt bases in Sidal, and that petitioners had zero

bases in Sidal during the audit years.

     C.   Applicable Caselaw

           1.   Introduction

     There are two types of payments at issue:    (1) the wire

transfer payments, which were made by Paulan to petitioners and,

then, by petitioners to Sidal, and (2) the Paulan direct

payments, which, in form, were made by Paulan directly to Sidal.

In each case, for petitioners to prevail, the evidence must show

that they, not Paulan, made loans to Sidal, and that Sidal’s

resulting indebtedness ran directly to them, not to Paulan.      See,

e.g., Prashker v. Commissioner, 59 T.C. 172, 176 (1972) (“[t]he

key question is whether or not the debt of the corporation runs

‘directly to the shareholder’”.).    A finding that Sidal’s

indebtedness ran to Paulan, a partnership with passthrough

characteristics, rather than directly to petitioners, its

partners, would not satisfy that requirement.    See Frankel v.

Commissioner, 61 T.C. 343 (1973), affd. without published opinion

506 F.2d 1051 (3d Cir. 1974).    Moreover, the evidence must show

that the payments created indebtedness from Sidal to petitioners

on the dates of each payment to Sidal.    Petitioners’ subsequent

recharacterization of those payments as back-to-back loans,

through them, would not, on account of that recharacterization,
                              - 21 -

give petitioners any debt-financed bases in Sidal.   See Underwood

v. Commissioner, 535 F.2d 309 (5th Cir. 1976), affg. 63 T.C. 468

(1975); Bhatia v. Commissioner, T.C. Memo. 1996-429; Shebester v.

Commissioner, T.C. Memo. 1987-246; see also Hitchins v.

Commissioner, 103 T.C. 711, 716-718 (1994).

          2.   Paulan Direct Payments

     Because the Paulan direct payments were, in fact, payments

from Paulan directly to Sidal (and Sidal repaid Paulan directly),

petitioners must prove that Paulan, in making those payments (and

in receiving the repayments), was acting on behalf of (i.e., as

agent of) petitioners, who were the actual lenders to Sidal.    Put

another way, petitioners must establish facts sufficient for us

to draw the legal conclusion that, on account of the Paulan

direct payments, Sidal was indebted to them, not to Paulan.

Petitioners claim that it is Indiana law that governs whether a

debtor-creditor relationship exists and, under Indiana law,

intent governs.   Petitioners cite Union Sec., Inc. v. Merchants’

Trust and Sav. Co., 185 N.E. 150, 153 (Ind. 1933), in which the

Supreme Court of Indiana set forth the test for distinguishing

between a loan and a sale:   “The test which determines whether

the real transaction between the parties was a loan or a sale is

the intention of the parties, and their intention is to be

ascertained from the whole transaction, including the conduct of

the parties as well as their written agreement.”   Intent is,
                               - 22 -

indeed, important.   We have said:   “Whether a transfer of money

creates a bona fide debt depends upon the existence of an intent

by both parties, substantially contemporaneous to the time of

such transfer, to establish an enforceable obligation of

repayment.”    Delta Plastics Corp. v. Commissioner, 54 T.C. 1287,

1291 (1970).   We also agree with the Supreme Court of Indiana

that the we must make an objective appraisal of intent.        See,

e.g., Hubert Enters., Inc. & Subs. v. Commissioner, 125 T.C. 72,

91 (2005) (“The subjective intent of the parties to a transfer

that the transfer create debt does not override an objectively

indicated intent to the contrary.”).     Thus, petitioners’ beliefs

are not necessarily determinative.      See, e.g., Bhatia v.

Commissioner, supra (stipulated conclusory statements by sole

shareholder of two S corporations in respect of bookkeeping

entries evidencing shareholder’s assumption of indebtedness

running from one corporation to the other insufficient to

establish bona fides of the transactions in question and their

economic substance); Burnstein v. Commissioner, T.C. Memo. 1984-

74 (testimony of sole shareholders of two S corporations that,

when they caused one corporation to transfer money to the other,

they intended and believed that they were actually transferring

their own money is not relevant to the question of whether they

actually incurred risk of nonrepayment).
                              - 23 -

     Moreover, transfers between related parties are examined

with special scrutiny.   Hubert Enters., Inc. and Subs. v.

Commissioner, supra at 91.   In the circumstances of this case,

where the entities involved in the transactions are wholly owned

by petitioners, petitioners bear a heavy burden of demonstrating

that the substance of the transactions differs from their form.

See, e.g., Bergman v. United States, 174 F.3d 928, 933 (8th Cir.

1999).   Nevertheless, “[t]he existence of a close relationship

between the parties to the transaction `is not necessarily fatal

if other elements are present which clearly establish the bona

fides of the transactions and their economic impact’”.    Id.

(quoting Bhatia v. Commissioner, supra).   In Culnen v.

Commissioner, T.C. Memo. 2000-139, revd. on another issue 28 Fed.

Appx. 116 (3d Cir. 2002), the uncontradicted testimony was that

the taxpayer had for many years used his controlled, profitable

corporation as an incorporated pocketbook, having the corporation

make payments on his behalf that were posted to the corporation’s

books as loans to the taxpayer, creating a loan balance, which,

periodically, the taxpayer would liquidate by making payments to

the corporation.   We found that, in substance, the corporation’s

advances to a loss corporation (an S corporation) in which the

taxpayer was a shareholder constituted economic outlays or

payments on the taxpayer’s behalf, thereby creating a tax basis

for the taxpayer in the S corporation under section
                                - 24 -

1366(c)(1)(B).    We reached a similar conclusion in Yates v.

Commissioner, T.C. Memo. 2001-280.

           3.    The Wire Transfer Payments

     In the case of the wire transfer payments, the issue is

whether the payments were (1) in substance, as well as in form,

back-to-back loans from Paulan to petitioners and from

petitioners to Sidal or (2) direct loans from Paulan to Sidal,

with petitioners serving as mere conduits for the transfer of

funds.   If we find the latter to be the case, we must apply the

so-called step transaction doctrine and ignore, as without

independent legal significance, the same-day wire transfers from

Paulan to each petitioner and from each petitioner to Sidal.     See

Aiken Indus. Inc. v. Commissioner, 56 T.C. 925, 934 (1971)

(doctrine applied to disregard an intermediate back-to-back loan

designed to avoid the withholding of U.S. tax on interest

payments to a foreign corporation).      If we ignore petitioners’

participation in the transactions, as without legal significance,

then, as in the case of the Paulan direct payments, the issue

will be whether Paulan made funds available for the use of (and

collected repayments of principal and interest from) Sidal as

agent for or on behalf of petitioners.
                               - 25 -

     D.   Discussion

           1.   The Economic Outlay Requirement

     Respondent’s principal argument is that petitioners failed

to satisfy the requirement, referred to in a number of cases,

e.g., Bergman v. United States, supra at 932; Hitchins v.

Commissioner, 103 T.C. at 715, that an increased basis in an S

corporation must entail an “actual economic outlay” by the

shareholder taxpayer.   In respondent’s view, that requirement is

met only if the taxpayer invests in or lends to the S corporation

his own funds, or funds borrowed from an unrelated party, to whom

he is personally liable.   We reject that view.   As we made clear

in Yates v. Commissioner, supra, and Culnen v. Commissioner,

supra, the fact that funds lent to an S corporation originate

with another entity owned or controlled by the shareholder of the

S corporation does not preclude a finding that the loan to the S

corporation constitutes an “actual economic outlay” by the

shareholder.

     It is not unusual for an individual to conduct multiple

businesses through multiple entities, some or all of which are

passthrough entities (e.g., S corporations or partnerships).    Nor

is it unusual for one or more of those entities to be profitable

and one or more to be unprofitable.     Where the loss entity is an

S corporation, we find no categorical rule, under section

1366(d)(1)(B), the regulations thereunder, see sec. 1.1366-2(a),
                             - 26 -

Income Tax Regs., the applicable caselaw, or, indeed, as a matter

of plain common sense, requiring a common shareholder to fund the

S corporation’s losses with funds from his mattress or with funds

borrowed by him from a bank or other unrelated party, rather than

with funds obtained from another controlled entity, in order to

obtain a basis in the unprofitable S corporation to the extent of

the funding.

     Recognizing, as he must, that Culnen v. Commissioner, supra

supports petitioners’ position in principle, respondent attempts

to distinguish that case on the ground that, in Culnen, the funds

lent to the unprofitable S corporation were derived from the

after-tax profits of a related corporation, whereas the funds

supplied by Paulan were, in a preliminary step, borrowed from

unrelated banks or, in one instance, from Bavaria, Inc., a

corporation wholly owned by Robert and Lovella.   A profitable

entity’s use of undistributed after-tax profits that, in essence,

belong to its controlling shareholders or partners, for advances

to an S corporation in which those same shareholders or partners

are investors, is consistent with the argument that the

profitable entity is acting on their behalf.   It is not, however,

indispensable to that argument.   Even though Paulan borrowed

money to fund Sidal’s losses, Paulan might still have been acting

on petitioners’ behalf in advancing the borrowed funds to Sidal.

In that connection, we note that, although Paulan did not possess
                                - 27 -

the cash or cash equivalent resources necessary to fund Sidal’s

losses, it did own valuable real property that could be (and was)

used on petitioners’ behalf as collateral for the bank loans.

Where the controlled entity owns assets that, in essence, belong

to the controlling shareholders or partners and can be used to

obtain loans on behalf of the controlling shareholders or

partners, we see no need to distinguish Culnen on the basis of

the liquidity of the controlled entity’s assets.

          2.    Sufficiency of Petitioners’ Evidence

          a.    The Paulan Direct Payments

          (1)    Introduction

     We have placed a high bar before any taxpayer who would

disavow the form of a direct loan between two entities he

controls and, instead, treat the loan as back-to-back loans

through him.    See, e.g., Shebester v. Commissioner, T.C. Memo.

1987-246 (the taxpayer “may not so easily disavow the form of * *

* [his] transaction”); Burnstein v. Commissioner, T.C. Memo.

1984-74 (“‘A transaction is to be given its tax effect in accord

with what actually occurred and not in accord with what might

have occurred.’” (quoting Don E. Williams Co. v. Commissioner,

429 U.S. 569, 579 (1977))).     In both Shebester and Burnstein, the

taxpayer’s attempt to recast a direct loan between commonly

controlled entities as back-to-back loans through the taxpayer-

owner was unsuccessful.   In Yates v. Commissioner, T.C. Memo.
                              - 28 -

2001-280, and Culnen v. Commissioner, T.C. Memo. 2000-139, that

attempt was successful.   Petitioners argue that their

circumstances are controlled by Yates and Culnen.

     Petitioners’ argument that the Paulan direct payments

constituted bona fide back-to-back loans through them

individually is essentially premised on two grounds:     (1) Like

the taxpayers in Yates and Culnen they have historically used

Paulan as an “incorporated pocketbook”, to discharge their

personal obligations, and the advances to Sidal are merely

another example of that practice; and (2) after respondent’s

denial of shareholder basis for Paulan’s pre-1997 advances to

Sidal, petitioners, at Michel’s direction, structured all

subsequent Paulan advances to Sidal in a manner intended to

constitute bona fide back-to-back loans, an intent that was

clearly manifested by the promissory notes, the minutes, and the

accounting for those advances by Paulan and Sidal.     We shall

consider those grounds in turn.

          (2)   Status of Paulan as an “Incorporated Pocketbook”

     In Yates v. Commissioner, supra, over a 4-year period, the

taxpayers wrote 409 checks on the payor corporation’s account

totaling $1,831,156 for various personal expenses and, at the

taxpayer husband’s direction, the payor corporation’s personnel

wrote 113 checks totaling $2,231,248 “to or for the * * *
                               - 29 -

[taxpayers].”   We concluded that the taxpayers “used * * * [the

payor corporation] as an incorporated pocketbook.”

     In Culnen v. Commissioner, supra, we found that “for many

years (including the years in question), the * * * [taxpayer] had

used * * * [the payor corporation] as an incorporated pocketbook,

having the corporation make payments on his behalf, which

payments were posted to * * * [the payor corporation’s] books as

loans to * * * [the taxpayer].”

     In both Yates and Culnen, we understood the term

“incorporated pocketbook” to describe the taxpayer’s habitual

practice of having his wholly owned corporation pay money to

third parties on his behalf.   Whether that practice is habitual

and whether it is probative of whether any ambiguous payment is

being made by the corporation on behalf of its owner (as opposed

to on its own behalf) are questions of fact to be resolved on the

basis of the particular facts of the case.   The term

“incorporated pocketbook” describes a set of facts, not a legal

conclusion.   It is not a term of art.

     The evidence indicates that, over a 5-year period (1996-

2000), Paulan wrote 55 checks (the 55 checks) to or on behalf of

petitioners totaling $689,784 (summarized in a schedule entitled

“Paulan Properties Summary of Partners Draw Checks”).15   Of those


     15
        The schedule lists 20 additional checks totaling
$169,364, but it is not clear that any of those checks were
                                                   (continued...)
                                - 30 -

checks, 21 (totaling $195,286) were written to various taxing

authorities in payment of petitioners’ personal tax liabilities

(11 for Al, 10 for Sid), and three (totaling $6,593) went to pay

insurance premiums for Sid.     The other 31 checks (totaling

$487,905) (the 31 checks) were written to petitioners (16 to Al,

15 to Sid, all listed under the heading “General”), presumably,

to use in any way they saw fit.     There is no evidence that the 55

checks were treated on Paulan’s books as anything other than

distributions to petitioners.

     We do not consider the 31 checks as anything other than

distributions of accumulated profits or, if more than accumulated

profits, as return of capital.    Being written to petitioners,

those checks are not evidence of their use of Paulan as an

incorporated pocketbook; i.e., to make payments directly to third

parties on behalf of one or the other of petitioners.    Moreover,

the 24 Paulan checks paid over a 5-year period for petitioners’

taxes and insurance (approximately five checks a year) are not of

a volume or of such a general nature that we are convinced that

Paulan habitually paid petitioners’ bills.    In sum, the 55 checks

and the conclusions to be drawn from them are insufficient to

convince us that the Paulan direct payments were made by Paulan

to Sidal on petitioners’ behalf.



     15
      (...continued)
written for or on behalf of either Sid or Al, personally.
                                - 31 -

           (3)   Analysis of Petitioners’ Evidence of Loans by
                 Them to Sidal

           (a)   Introduction

     Both Michel and petitioners gave uncontradicted testimony

that they believed the wire transfer and Paulan direct payments

were structured so as to constitute back-to-back loans from

Paulan to petitioners and from petitioners to Sidal, thereby

generating bases for petitioners in Sidal equal to the loan

amounts.   As we have already noted, however, supra section

III.C.2. of this report, petitioners’ beliefs are not necessarily

determinative, and we must be objective in judging intent.

Before we address the particular facts in front of us, we make

some preliminary observations.

     Yates v. Commissioner, supra, and Culnen v. Commissioner,

supra, instruct us that we are not required to find that Sidal’s

indebtedness ran to Paulan, rather than to petitioners, solely

because the flow of the borrowed funds ran directly from Paulan

to Sidal, and the flow of the principal and interest payments ran

directly from Sidal to Paulan.    See also Gilday v. Commissioner,

T.C. Memo. 1982-242 n.8, in which we were untroubled by such

direct payments and characterized a scenario in which the S

corporation repays the shareholder who in turn repays the lender

as “the utilization of fruitless steps.”

     Nor do we consider it fatal to petitioners’ position that

the back-to-back loan structure was adopted in order to enable
                              - 32 -

petitioners to acquire tax bases in Sidal; i.e., for tax

minimization or avoidance purposes.    This case does not involve a

brief, circular flow of funds beginning and ending with the

original lender, the sole purpose of which is to generate a tax

basis in an S corporation.   See Kaplan v. Commissioner, T.C.

Memo. 2005-218, and Oren v. Commissioner, T.C. Memo. 2002-172,

affd. 357 F.3d 854 (8th Cir. 2004), in both of which we found

that such an arrangement had no economic substance and,

therefore, did not involve the actual economic outlay required to

create a basis in the S corporation.   The loans to Sidal had a

valid business purpose; i.e., to provide working capital for the

operation and expansion of Sidal’s business.   Although the back-

to-back loan structure was adopted in order to achieve tax bases

for petitioners in Sidal equal in amount to the loans, that is a

permissible motivation for that structure.   See Helvering v.

Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (“Anyone may so arrange

his affairs that his taxes shall be as low as possible”), affd.

293 U.S. 465 (1935).   See also Gilday v. Commissioner, supra, in

which we sustained the taxpayer-shareholder’s loan basis in an S

corporation despite the parties’ agreement that the transaction

which gave rise to that basis “was motivated by tax

considerations.”

     It is necessary, however, that petitioners’ intent to

establish a back-to-back loan structure in connection with the
                                - 33 -

Paulan direct payments be clearly manifested by the actions of

the parties to those transactions; viz, petitioners, Paulan, and

Sidal.    With that thought in mind, we examine the parties’

actions as evidenced by the promissory notes, the minutes, and

the accounting entries.

            (b)   The Promissory Notes

     Petitioners point to the promissory notes as documentary

evidence of the back-to-back loan structure and, in particular,

of “real, enforceable loan obligations between * * * [them] and

Sidal.”    Respondent argues that because the promissory notes

reflected loans that were unsecured, yet provided for the same

interest rates as the secured bank loans to Paulan (i.e., because

the terms of those loans were not arm’s-length), and because the

execution dates of the notes are uncertain, they cannot be

considered “genuine”.

     We do not find the alleged failure of the promissory notes

to satisfy an arm’s-length standard to be of much help in

deciding the issue of whether those notes do, in fact, reflect

bona fide indebtedness from Sidal to petitioners and from

petitioners to Paulan, which is the issue in this case.    If, as

respondent argues, the interest rates on the unsecured

indebtedness from Sidal to petitioners and from petitioners to

Paulan, as set forth in the promissory notes, are too low, those

rates may be subject to increase pursuant to section 482.      See
                               - 34 -

sec. 1.482-2(a)(1), Income Tax Regs.    Nonetheless, we agree with

respondent that the promissory notes are entitled to little or no

weight in our consideration of whether the back-to-back loans

claimed by petitioners actually existed.

     Neither petitioner could recall the actual dates upon which

the promissory notes were executed.     They could only agree that

the notes were executed sometime between 1997 and 2000.    We infer

from that testimony that the notes were not executed

contemporaneously with the wire transfer and the Paulan direct

payments but were, instead, backdated to appear contemporaneous

with those payments.    Moreover, none of the eight sets of

promissory notes bears an effective date that corresponds to the

Paulan direct payment to which it relates.

     Five sets of notes bear effective dates that are between 3

days and more than 9 months subsequent to the corresponding

Paulan direct payments.   Even if we were to accept as accurate

the stated effective dates of those notes, the notes are more

reflective of attempts to recharacterize prior debts from Sidal

to Paulan as back-to-back loans through petitioners than they are

of back-to-back loans as of the dates of the actual Paulan direct

payments.   Therefore, at best, those notes suggest the creation

of a back-to-back loan structure after the Paulan direct payments

to which they relate.   Such a finding would not justify treatment

of those notes as anything more than guaranties of Sidal’s
                              - 35 -

existing indebtedness to Paulan, which would be ineffective to

create bases in Sidal under section 1366(d)(1)(B).    See Bergman

v. United States, 174 F.3d 928 (8th Cir. 1999); Underwood v.

Commissioner, 535 F.2d 309 (5th Cir. 1976).

     Conversely, the other three sets of promissory notes predate

the Paulan direct payments to which they relate.   Those

promissory notes also fail to support a finding that the

corresponding Paulan direct payments, in substance, created bona

fide indebtedness from Sidal to petitioners and from petitioners

to Paulan in the amounts set forth and on the dates thereof.    See

Perry v. Commissioner, 392 F.2d 458 (8th Cir. 1968) (predated

notes insufficient to prove indebtedness from an S corporation to

the taxpayer shareholder), affg. 47 T.C. 159 (1966); Thomas v.

Commissioner, T.C. Memo. 2002-108 (promissory note bearing a date

prior to the transaction to which it relates given no weight),

affd. 67 Fed. Appx. 582 (11th Cir. 2003).

          (4)   The Minutes

     The Paulan minutes, in essence, reflect meetings at which

petitioners, acting on behalf of Paulan, authorized loans to

themselves individually, and the Sidal minutes, in essence,

reflect meetings at which petitioners, acting on behalf of Sidal,

authorized borrowings from themselves individually.   As mere

authorizations, those meetings are not evidence that the loans,
                             - 36 -

in fact, occurred, but they can be evidence of an intent to make

the loans.

     The purported meeting dates all precede the stipulated

date(s) when the minutes were drafted.   Although it is

necessarily the case that meeting minutes cannot be drafted until

after the meeting, we give little or no evidentiary weight to

minutes that follow the alleged   meetings to which they relate by

periods of anywhere from a month to more than 3 years.    Those

delays, in this case, indicate an attempt to provide an after-

the-fact paper trail of back-to-back loans through petitioners

rather than corroboration of an actual intent to make such loans,

which existed at the time of the Paulan direct payments.    Even

the Sidal minutes drafted with respect to the October 31, 2000,

Paulan direct payments are stipulated to have been “drafted and

executed sometime after * * * [that date].”   There is no evidence

as to how long after October 31, 2000, the minutes were drafted.

Therefore, we have no reason to give more evidentiary weight to

those minutes than to the minutes relating to the earlier

payments.

     We also note that, because the minutes of each of Sidal’s

board of directors meetings specify as the meeting date the

alleged effective date of the corresponding set of promissory

notes, five of the eight Sidal board meetings are necessarily

alleged to have been held after the borrowings authorized during
                                 - 37 -

those alleged meetings.     (As noted supra, five of the eight sets

of promissory notes bear effective dates subsequent to the Paulan

direct payment(s) to which they relate.)      Because after-the-fact

authorizations (as opposed to genuine ratifications) are not

credible, that aspect of a majority of the minutes further

supports our conclusion that the minutes merit little or no

evidentiary weight.     In fact, it supports the conclusion that

none of the alleged Paulan or Sidal partner/board meetings

actually took place in the manner or at the times stated in the

minutes.16

             (5)   The Accounting Entries

     Neither the promissory notes nor the minutes furnish

significant evidentiary support for petitioners’ claim that the

Paulan direct payments constituted back-to-back loans, which

would give them tax bases in Sidal.       Therefore, their claim that

the Paulan direct payments constituted back-to-back loans

(through them, to Sidal), rests solely upon the accounting for

those payments.




     16
        Because all of the alleged meetings of the Paulan and
Sidal partners/directors (i.e., petitioners) are alleged to have
occurred on the alleged effective dates of the promissory notes
to which they relate, we infer that those meeting dates were
selected to be consistent with the promissory note effective
dates and not because they represent dates when petitioners, in
their capacities as partners/directors of Paulan and Sidal,
actually held meetings.
                              - 38 -

     Freyberger, the BR Associates, Inc. controller, testified

that one of his functions, particularly on behalf of Sidal, was

to track the cashflow in and out.   He stated that the “tax

characterization” of any cash transfer, on the books of both

Paulan and Sidal, was made by Michel.   In that connection, he

testified that he prepared the annual trial balances, which he

gave to Michel, who was responsible for making any adjustments.

     Michel testified that he followed that procedure (yearend

adjusting entries) with respect to the Paulan direct payments by

recharacterizing, as back-to-back loans through petitioners, the

notes payable and notes receivable that had been   initially

recorded by Freyberger (consistent with the actual cashflow) as

debt obligations running from Sidal directly to Paulan.

     Contrary to Michel’s testimony, not all of the Paulan direct

payments, which were originally recorded by Freyberger as giving

rise to notes payable from Sidal to Paulan, were the subject of

yearend adjusting entries on the Sidal and Paulan adjusted trial

balances.   The July 11, 1997, Paulan direct payment of $1.2

million and the 1998 Paulan direct payments to the extent of

$928,000 are reflected on all of the Paulan and Sidal trial

balances in evidence (subsequent to those payments) as Sidal

notes payable (“N/P”) to Paulan or Paulan notes receivable

(“N/R”) from Sidal.   The 1999 and 2000 Paulan direct payments,

like their 1997 and 1998 counterparts, were also initially
                              - 39 -

recorded on Sidal’s adjusted trial balances as notes payable

(“N/P”) to Paulan; but those payments were reclassified at

yearend on those trial balances as notes payable (“N/P”) to

petitioners (one-half of each payment constituting a note payable

to each petitioner).   We assume corresponding entries and yearend

adjusting entries were made on Paulan’s 1999 and 2000 adjusted

trial balances (which are not in evidence) to convert receivables

from Sidal into receivables from petitioners.

     Because the 1997 and 1998 Paulan direct payments were always

reflected on Sidal’s and Paulan’s books as giving rise to notes

payable from Sidal to Paulan, those accounting entries furnish no

support for treating those payments as, in substance, back-to-

back loans from Paulan to petitioners and from petitioners to

Sidal.   The issue with respect to the 1999 and 2000 Paulan direct

payments is whether the yearend adjusting entries alone justify

such back-to-back loan treatment for those payments.   We find

that they do not.

     In both Yates v. Commissioner, T.C. Memo. 2001-280, and

Culnen v. Commissioner, T.C. Memo. 2000-139, we reviewed

accounting systems that entailed temporary postings or entries by

a bookkeeper reflecting direct loans from the taxpayer’s

controlled entity to an S corporation in which the taxpayer was a

shareholder (which entries were consistent with the actual

cashflow), followed (before yearend) by adjusting entries
                              - 40 -

reclassifying the loans as back-to-back loans through the

taxpayer.   In both cases, we found that the system was indicative

of the contemporaneous treatment of the transactions as back-to-

back loans through the taxpayer.   In those cases, however, the

adjusting entries were consistent with an established course of

conduct whereby the payor corporation routinely made payments on

behalf of the taxpayer shareholder.    As noted supra, petitioners

have established no such course of conduct for Paulan.

     Moreover, in each of Yates, and Culnen, the taxpayer-

shareholder was intimately involved in recording the intercompany

advances to the S corporation as giving rise to payables from the

S corporation to him.   In Yates, it was the taxpayer who directed

his accountant to make intercorporate funds transfers and, by

yearend, to record those transfers either as distributions to him

followed by capital contributions to the payee S corporation or

as back-to-back loans to the S corporation through him.    In

Culnen, the taxpayer’s regular accountant testified that it was

the taxpayer who routinely, over a 20-year period, directed the

bookkeeper for the payor corporation to have that corporation

write checks on his behalf and charge the amounts to his loan

account with the corporation; and the taxpayer’s outside

accountant testified that she made the adjusting entries

classifying the payor corporation’s payments to the loss S

corporation as back-to-back loans through the taxpayer on the
                             - 41 -

basis of conversations with the taxpayer.   In this case, there is

no evidence that petitioners were even aware of the Paulen and

Sidal accounting entries designed to show back-to-back loans

through them or of the fact that the appropriate adjusting

entries were not made in connection with the July 11, 1997 and

1998, Paulan payments to Sidal.   Rather, the testimony at trial

indicated that petitioners relied completely upon Michel for all

tax planning, and that it was Michel who, alone, was responsible

for making the accounting entries consistent with his plan to

generate tax bases for petitioners in Sidal.   Petitioners, who

lacked any hands-on involvement with the accounting for the

Paulan direct payments, cannot, like the taxpayers in Yates, and

Culnen, rely on those accounting entries to prove the existence

of binding debt obligations from Sidal to them and from them to

Paulan arising out of those payments on the dates thereof.

     In Burnstein v. Commissioner, T.C. Memo. 1984-74, we

rejected the taxpayer’s attempt to reclassify intercorporate

loans as back-to-back loans through the taxpayers, commenting as

follows.

     All [the taxpayers] really did was make journal
     adjustments at the end of each year (when it could be
     determined that * * * [the transferee S corporation]
     would have a net operating loss) to reclassify the
     transferred funds on the books of * * * [the transferor
     corporation] as accounts receivable due from [the
     taxpayers] and on the books of * * * [the transferee S
     corporation] as accounts payable due [the taxpayers].
     * * *
                               - 42 -

          * * * such reclassification is insufficient to
     create “indebtedness of the corporation to the
     shareholder” withing the meaning of * * * [the
     predecessor of section 1366(d)(1)(B)]. * * *

Similarly, we do not believe that the yearend adjusting entries

overseen by Michel with respect to some, but not all, of the

Paulan direct payments were sufficient to justify treating those

payments as giving rise to indebtedness from Sidal to petitioners

on the dates the payments were made.     At best, they caused a

yearend reclassification of Sidal’s original debt to Paulan,

which was insufficient to provide petitioners with debt bases in

Sidal under section 1366(d)(1)(B).      See Underwood v.

Commissioner, 535 F.2d 309 (5th Cir. 1976); Bhatia v.

Commissioner, T.C. Memo. 1996-429; Shebester v. Commissioner,

T.C. Memo. 1987-246; Burnstein v. Commissioner, supra.

          (6)   Conclusion

     For the reasons stated, we find that, despite petitioners’

overall intent to take the steps necessary to establish tax bases

in Sidal beginning in 1997, the steps taken (the promissory

notes, the minutes, and the accounting entries) were ineffective

to carry out that intent.    At best, those steps amounted to a

reclassification of initial indebtedness from Sidal to Paulan.

Put quite simply, petitioners, in conjunction with Michel, paid

insufficient attention to detail.    Another example of that

failing is exemplified by the failure to have Sidal issue

information returns (IRS Forms 1099) to petitioners in connection
                                - 43 -

with its interest payments (actually made to Paulan) on the

alleged indebtedness.

     We find that petitioners have failed to provide credible

evidence that the Paulan direct payments entitled them to any

bases in Sidal under section 1366(d)(1)(B).

            3.   The Wire Transfer Payments

     Unlike the Paulan direct payments, the wire transfer

payments, in form, suggest a back-to-back loan structure through

petitioners as the intermediate borrowers (from Paulan) and

lenders (to Sidal).     Moreover, the adjusted trial balance for

1997 (and for all subsequent years) always reflected the payments

as giving rise to payables from Sidal to petitioners and from

petitioners to Paulan.     Therefore, there was no necessity for a

1997 yearend adjusting entry.     Nonetheless, consistent with the

Paulan direct payments, Sidal made all principal and interest

payments directly to Paulan.

     As in the case of the Paulan direct payments, and largely

for the same reasons, we give no significant evidentiary weight

to the promissory notes and minutes relating to the wire transfer

payments.    Petitioners cannot recall when the promissory notes,

dated December 18, 1997, were executed (except insofar as they

could agree upon an execution date sometime between 1997 and

2000), and petitioners have stipulated that the applicable

minutes authorizing those November 24, 1997, payments were
                              - 44 -

drafted no earlier that June 30, 2000.   Moreover, both the Paulan

and the Sidal minutes specify a meeting date (December 18, 1997)

on which the alleged loans (from Paulan to petitioners and from

petitioners to Sidal) were authorized that is more than 3 weeks

after the wire transfer payments actually occurred.

     Thus, it is the form of the wire transfer payments and the

manner in which they were consistently recorded on both Paulan’s

and Sidal’s books that furnish the evidentiary support for

petitioners’ position that those payments constituted back-to-

back loans giving petitioners bases in Sidal to the extent

thereof.   We find that that evidence is sufficient to sustain

petitioners’ position.   Although we would normally be inclined to

view petitioners’ participation in the transactions, if they were

essentially conduits for transfers of funds from Paulan to Sidal,

as without independent legal significance, in this instance

petitioners’ involvement, at some personal inconvenience,17

represented a concrete manifestation of an intent to create debt

from Sidal to them and from them to Paulan.18   The



     17
        Petitioners decided to abandon the wire transfer
structure for subsequent payments from Paulan to Sidal as an
inconvenient (to them) interruption of the interentity flow of
funds.
     18
        As discussed supra, were we to view the same-day wire
transfers from Paulan to petitioners and from petitioners to
Sidal as without independent legal significance, we would
disregard those intermediate payments under the so-called step
transaction doctrine.
                                - 45 -

contemporaneous (and subsequent) bookkeeping for the wire

transfer payments represented a further manifestation of that

intent.19

     As noted supra (note 7), the amounts of basis attributable

to the wire transfer payments that carried over to 1999 are not

certain.     It is certain, however, that those basis amounts are

substantially less than Sidal’s 1999 ordinary loss, thereby

enabling each petitioner to deduct only a small portion of that

loss and none of Sidal’s 2000 ordinary loss.     We assume that the

parties will be able to arrive at agreed carryover basis figures

in the Rule 155 computation.

     E.     Conclusion

     The Paulan direct payments did not provide petitioners with

any bases in Sidal under section 1366(d)(1)(B).     The wire

transfer payments did provide petitioners with carryover bases in

Sidal under that section sufficient to enable them to deduct a

small portion of Sidal’s 1999 ordinary loss and none of Sidal’s

2000 ordinary loss.


                                           Decisions will be entered

                                      under Rule 155.



     19
        As in Gilday v. Commissioner, T.C. Memo. 1982-242 n.8,
we regard the payments of principal and interest by Sidal
directly to Paulan rather than to petitioners who, in turn, would
have had to transmit those payments to Paulan, as the permissible
avoidance of “fruitless steps”.
