                        T.C. Memo. 2005-218



                     UNITED STATES TAX COURT



                  MARK O. KAPLAN, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 3624-04.              Filed September 20, 2005.


     Albert L. Grasso, for petitioner.

     Kathleen C. Schlenzig, for respondent.



                        MEMORANDUM OPINION


     THORNTON, Judge:   Respondent determined a $123,543

deficiency with respect to petitioner’s 1994 income tax and a

$188,964 deficiency with respect to petitioner’s 1997 income tax.

The deficiencies arise from respondent’s denial of petitioner’s

asserted basis in his wholly owned S corporation, Marc

Construction and Development Co. (Marc), which resulted in
                               - 2 -

disallowance of petitioner’s passthrough Marc losses pursuant to

section 1366(d).1   The issue for decision is the amount of

petitioner’s adjusted basis in Marc as of December 31, 1997.2

                            Background

     The parties submitted this case fully stipulated pursuant to

Rule 122.   We incorporate herein the stipulated facts.    When

petitioner filed his petition, he resided in Chicago, Illinois.

Petitioner and His S Corporations

     Petitioner is a real estate developer.     During the relevant

years, he conducted his operations through multiple entities,

including several wholly owned S corporations.     In addition to

Marc, these S corporations included:     Lakeview Development of

Barrington, Inc. (Lakeview); Pleasant Prairie Development, Inc.

(Pleasant Prairie); and Silver Glen Development, Inc. (Silver

Glen).

     For the year ending December 31, 1996, Marc sustained a loss

of $792,752 (the Marc loss).   At that time, petitioner had zero

adjusted basis in Marc.   Consequently, even though the Marc loss

was allocable to petitioner, see sec. 1366(b), he was unable to

deduct it in 1996, see sec. 1366(d).     The Marc loss carried over


     1
       All section references are to the Internal Revenue Code in
effect for the taxable years in issue. All rule references are
to the Tax Court Rules of Practice and Procedure, as amended.
     2
       The deficiency for 1994 results from respondent’s
disallowance of a carryback from 1997.
                                 - 3 -

to petitioner’s 1997 tax year.    See sec. 1366(d)(2).    Petitioner

took certain steps, as described below, to attempt to create

adjusted basis in Marc to enable him to deduct the Marc loss in

1997.

Petitioner Borrows $800,000 From the Bank

     On December 29, 1997, petitioner borrowed $800,000 from

Manufacturers Bank (the Bank), evidenced by his promissory note

(the note) of the same date.   The note’s maturity date was

January 30, 1998.   When he executed the note, petitioner prepaid

$1,000 of finance charges to the Bank.

     When he applied for the loan, petitioner did not provide the

Bank any financial statement, and he had no preexisting

relationship with the Bank.    The note was collateralized by two

Bank deposit accounts (the deposit accounts), one owned by

Lakeview and the other owned by Pleasant Prairie.    The deposit

accounts were opened for the sole purpose of facilitating the

loan between petitioner and the Bank.    When petitioner executed

the note, the deposit accounts had zero balances.

Petitioner Pays $800,000 to Marc

     Contemporaneously with the Bank loan, petitioner issued Marc

an $800,000 check drawn on his account at the Bank.      Marc

deposited the check in its account at the Bank.
                               - 4 -

Marc Pays $800,000 to Pleasant Prairie and Lakeview

     Contemporaneously with the transactions described above,

Marc paid the $800,000 loan proceeds to Pleasant Prairie and

Lakeview.   Specifically, on December 29, 1997, Marc issued

Lakeview a $550,000 check, which Lakeview deposited in its

account at the Bank.   Also on December 29, 1997, Marc issued to

Pleasant Prairie a $250,000 check, which Pleasant Prairie

deposited in its account at the Bank.   Prior to making this

payment, Marc had an account payable balance due to Pleasant

Prairie in the amount of $204,222.

Pleasant Prairie and Lakeview Pay Petitioner $800,000

     On or before January 8, 1998, petitioner borrowed $550,000

from Lakeview and $250,000 from Pleasant Prairie.3    Petitioner

deposited the proceeds in his account at the Bank.

Petitioner Repays Bank $800,000

     On January 8, 1998, petitioner paid off the note by issuing

the Bank a check in the amount of $800,000, drawn on his account

at the Bank.




     3
       The parties stipulated that petitioner borrowed the
$250,000 from Lakeview. On brief, however, the parties appear to
agree, consistent with other facts disclosed by the record, that
petitioner borrowed the $250,000 from Pleasant Prairie.
Accordingly, we decline to be bound by the apparently inadvertent
error in the stipulation. See Gulf Oil Corp. v. Commissioner, 87
T.C. 135, 159 n.4 (1986), affd. 914 F.2d 396 (3d Cir. 1990).
                               - 5 -

Items Reallocated From Silver Glen to Marc by Journal Entry

     As of December 31, 1997, Marc’s books and records showed

“Loans to stockholders” of $1,305,226.   This amount included, in

addition to the $800,000 Bank loan proceeds that petitioner

transferred to Marc on December 29, 1997 (and certain nongermane

items), $213,571 that had been recorded by Silver Glen and that

was made up of $159,116 of legal fees and a $49,000 loan from

petitioner.   By adjusting journal entry, these amounts had been

“reallocated” from Silver Glen to Marc as loans from petitioner.

Merger of Marc, Lakeview, and Pleasant Prairie

     On or about December 15, 1998, pursuant to section

368(a)(1)(A), Marc, Lakeview, and Pleasant Prairie merged into

Marc Development Company, a C corporation wholly owned by

petitioner.

Petitioner’s 1997 Tax Return and NOL Carryback to 1994

     On his 1997 Federal income tax return, petitioner reported

current-year ordinary income from Marc of $183,894, which he

offset against the $792,752 Marc loss that had been carried over

from 1996 pursuant to section 1366(d)(2).   Consequently, for 1997

petitioner reported a net loss from Marc of $608,858.

     On Schedule D, Capital Gains and Losses, of his 1997 income

tax return, petitioner reported a $49,000 long-term capital gain

from “Recapture of Loan Basis” with respect to the Silver Glen

loan that had been “reallocated” (as discussed above) by
                                - 6 -

adjusting journal entry from Silver Glen to Marc.   On the same

Schedule D, this $49,000 long-term capital gain was more than

offset by reported net long-term losses from partnerships, S

corporations, and fiduciaries in the amount of $230,976.

      For 1997, petitioner reported (after factoring in various

other items not at issue here) a net operating loss (NOL) of

$311,976.   Petitioner carried this NOL back to 1994 and filed a

Form 1045, Application for Tentative Refund, claiming a $123,543

overpayment for 1994.   Pursuant to section 6411, respondent made

a tentative allowance of the 1994 claimed overpayment.

Notice of Deficiency

      By notice of deficiency, respondent disallowed petitioner’s

claim to the $792,752 Marc carryover loss, on the ground that it

exceeded petitioner’s basis in Marc stock and debt for 1997.    As

a consequence, petitioner’s 1997 income was increased by

$792,752, wiping out petitioner’s NOL carryback to 1994.

Accordingly, respondent recaptured the $123,543 tentative

allowance of petitioner’s 1994 claimed overpayment and increased

petitioner’s 1994 tax by the same amount.

                            Discussion

I.   General Legal Principles

      Generally, an S corporation shareholder determines his or

her tax liability by taking into account a pro rata share of the

S corporation’s income, losses, deductions, and credits.    Sec.
                               - 7 -

1366(a)(1).   The shareholder may not take into account, however,

S corporation losses and deductions for any taxable year in

 excess of the shareholder’s adjusted basis in the S corporation

stock and debt.   Sec. 1366(d)(1).4

     In order to increase basis in an S corporation, the

shareholder must make an actual economic outlay; to satisfy this

requirement, even in circumstances where the taxpayer purports to

have made a direct loan to the S corporation, the taxpayer must

show that the claimed increase in basis was based on “‘some

transaction which when fully consummated left the taxpayer poorer

in a material sense.’”   Bergman v. United States, 174 F.3d 928,

932 (8th Cir. 1999) (quoting Perry v. Commissioner, 54 T.C. 1293,

1296 (1970), affd. 27 AFTR 2d 71-1464, 71-2 USTC par. 9502 (8th

Cir. 1971)); see Hitchins v. Commissioner, 103 T.C. 711, 715


     4
       More exactly, with respect to taxation of a shareholder of
an S corporation, sec. 1366(a)(1) provides:

     there shall be taken into account the shareholder’s pro
     rata share of the corporation’s

           (A) items of income (including tax-exempt
          income), loss, deduction, or credit the
          separate treatment of which could affect the
          liability for tax of any shareholder, and

          (B) nonseparately computed income or loss.

     The aggregate amount of losses and deductions taken into
account by such shareholder for a taxable year cannot exceed the
sum of: “(A) the adjusted basis of the shareholder’s stock in
the S corporation * * *, and (B) the shareholder’s adjusted basis
of any indebtedness of the S corporation to the shareholder”.
Sec. 1366(d)(1).
                                 - 8 -

(1994).    This doctrine ensures that the transaction has some

economic substance beyond the creation of a tax deduction.       Oren

v. Commissioner, 357 F.3d 854, 857 (8th Cir. 2004), affg. T.C.

Memo. 2002-172.

II.   The Parties’ Positions

      On his 1997 tax return, petitioner claimed the $792,752

Marc loss (carried forward from 1996), on the premise that

various events during 1997 created at least that much adjusted

basis in his Marc stock and debt.     Petitioner was unable to use

this entire loss in 1997 and carried a portion of it back to

1994.     In the notice of deficiency, respondent disallowed the

$792,752 loss on the ground that as of December 31, 1997,

petitioner had zero adjusted basis in the Marc stock and debt.5

        In this proceeding, the parties have narrowed their

differences.     Respondent now concedes that as of December 31,

1997, petitioner had adjusted basis in Marc stock of $321,859,

representing the income realized by Marc during 1997 and

allocable to petitioner as Marc’s sole shareholder.6


      5
       Respondent’s disallowance of petitioner’s claim to the
$792,752 Marc loss resulted in deficiencies for both 1997 and the
1994 carryback year. Apart from challenging the adequacy of
petitioner’s basis in Marc for 1997, respondent has not
challenged the propriety of petitioner’s carryback of the
$792,752 of Marc losses from 1997 to 1994.
      6
       The $321,859 is made up of $189,748 ordinary income from
Marc’s trade or business activities during 1997, Marc’s $133,975
of 1997 investment income, and a $1,864 sec. 1231 loss realized
                                                   (continued...)
                                - 9 -

     On brief, petitioner contends that he has established

adjusted basis in Marc stock and debt of $645,535 as of

December 31, 1997.7    This amount is made up of the $321,859 of

adjusted basis conceded by respondent, plus these three

additional items that petitioner contends created basis in Marc:

(1) $204,222 of the $800,000 proceeds from the 1997 Bank loan;

(2) $49,000 attributable to petitioner’s purported loan to Silver

Glen that was “reallocated” to Marc in 1997; and (3) $70,454 of

legal expenses that petitioner claims he paid on behalf of Marc

during 1997.   We consider these three items in turn.   The burden

of proof is on petitioner.    Rule 142(a).8




     6
      (...continued)
by Marc during 1997.
     7
       Petitioner thereby effectively concedes that he is not
entitled to $147,217 of the $792,752 loss he claimed on his 1997
tax return.
     8
       Effective for court proceedings arising in connection with
examinations commencing after July 22, 1998, if certain
requirements are met, sec. 7491(a) places the burden of proof on
the Commissioner with respect to any factual issue relevant to
ascertaining a taxpayer’s liability for any tax imposed by
subtitle A or B of the Code. Internal Revenue Service
Restructuring and Reform Act of 1998, Pub. L. 105-206, sec. 3001,
112 Stat. 726. Petitioner has neither alleged that sec. 7491(a)
applies nor established that the preconditions to its
applicability have been met. Accordingly, sec. 7491(a) does not
apply.
                                - 10 -

III.    Bank Loan Proceeds

       At the end of 1997, petitioner borrowed $800,000 from the

Bank.    Contemporaneously, petitioner purportedly lent Marc

$800,000, by writing a check for $800,000 to Marc, which

contemporaneously wrote checks totaling $800,000 to Lakeview and

Pleasant Prairie, which shortly thereafter paid $800,000 to

petitioner, who used the funds to pay off the Bank note, 11 days

after its creation.    The issue is whether petitioner made any

economic outlay to Marc so as to create basis therein.

       In Oren v. Commissioner, T.C. Memo. 2002-172, affd. 357 F.3d

854 (8th Cir. 2004), the Courts considered a circular funds-

juggling arrangement similar to that involved in the instant

case.    In Oren, the taxpayer borrowed funds from an S

corporation, Dart Transit Co. (Dart), which he controlled and

owned a majority interest in.    The taxpayer then lent these funds

to his two wholly owned S corporations; over time, these S

corporations lent the funds back to Dart.    This Court held that

the loan transactions had no net economic effect, noting that the

loan proceeds originated and ended with Dart.    This Court stated:

“The only significance of the transactions was the circular route

of the various checks and the wire transfer and the execution of

promissory notes.    The economic positions of the parties did not

change.”    Id.   Concluding that the circular loans involved no

actual economic outlay, this Court disallowed the taxpayer’s
                              - 11 -

claim for increased basis resulting from these transactions.     Id.

Affirming this Court’s decision, the Court of Appeals for the

Eighth Circuit agreed that the taxpayer’s loans to his S

corporations involved no actual economic outlays.   Oren v.

Commissioner, 357 F.3d at 858-859.

     Similarly, petitioner’s purported loan to Marc involved no

actual economic outlay.   In this case, as in Oren v.

Commissioner, T.C. Memo. 2002-172, the various disbursements

between the taxpayer and his S corporations were “the equivalent

of offsetting bookkeeping entries, even though they occurred in

the form of checks”.   The loan proceeds originated and ended with

the Bank.   The Bank loan was “collateralized” with $800,000 that

Lakeview and Pleasant Prairie deposited in their Bank accounts

contemporaneously with the Bank loan.   In effect, then, the Bank

loan proceeds constituted the collateral for the Bank loan.    As

far as the record reveals, the loan proceeds never left the Bank

in the 11 days between the time the note was created and the time

it was paid off.9


     9
       We are mindful that there was a note evidencing the
$800,000 loan from the Bank and that petitioner prepaid $1,000 in
interest charges to the Bank. Even if we were to assume,
however, that there was a bona fide loan between the Bank and
petitioner, this circumstance would not answer the question of
whether petitioner made any actual economic outlay to Marc.
Indeed, petitioner has conceded that most of the $800,000
transaction was a “circular loan” that created no basis in Marc
for petitioner. In making this concession, petitioner implicitly
acknowledges that the bona fides of the Bank loan are not
                                                   (continued...)
                              - 12 -

     On brief, citing Oren v. Commissioner, 357 F.3d 854 (8th

Cir. 2004), and Bergman v. United States, 174 F.3d 928 (8th Cir.

1999), petitioner states that he “agrees with all of those

judicial decisions indicating that circular loans do not create

basis.”   Petitioner concedes that the $550,000 that Marc

disbursed to Lakeview reflects a circular loan and does not

provide basis.   With respect to the $250,000 that Marc disbursed

to Pleasant Prairie, however, petitioner’s position is more

subtle.   Petitioner notes that before Marc made this

disbursement, it owed Pleasant Prairie $204,222.   Consequently,

petitioner argues, the $204,222 did not create a loan between

Marc and Pleasant Prairie but rather extinguished a debt.    Since

there was no loan between Marc and Pleasant Prairie, petitioner

concludes, there was no “circular loan”, and hence the

transaction increased petitioner’s adjusted basis in Marc by

$204,222.10

     As best we understand it, petitioner’s argument appears to

be that because Marc could not recover $204,222 of the $250,000

that it purportedly lent to Pleasant Prairie, petitioner was

exposed to the risk of not recovering $204,222 of his $800,000



     9
      (...continued)
controlling in deciding whether petitioner made any economic
outlay to Marc.
     10
       Petitioner concedes that the remaining $45,778 of the
$250,000 transaction was a circular loan and provides no basis.
                               - 13 -

“loan” to Marc and thereby was exposed to the risk of repaying

$204,222 of the Bank loan from his own pocket.    Any such risk to

petitioner was illusory.    In the first instance, by virtue of

Pleasant Prairie’s and Lakeview’s depositing (cumulatively) the

entire $800,000 of the Bank loan proceeds into their Bank

accounts contemporaneously with the Bank’s making the loan, there

was no significant risk that the Bank would enforce payment

against petitioner in the event of a default.    Moreover, inasmuch

as petitioner wholly owned and controlled these S corporations

and their bookkeeping, they obviously were not going to act

adversely to his interests.    In any event, as a result of the

December 15, 1998, merger of Marc, Lakeview, and Pleasant Prairie

into a new C corporation wholly owned by petitioner, all

purported loan obligations between petitioner and his S

corporations were extinguished; i.e., after the merger,

petitioner purportedly would have owed the new corporation

$800,000, which would have been exactly offset by the $800,000

that the new corporation purportedly would have owed petitioner.

These circumstances further denote “the inherent lack of

substance in the loans.”    Oren v. Commissioner, T.C. Memo. 2002-

172.

       In sum, we envision no realistic scenario in which

petitioner’s purported loan to Marc would have or could have made

him poorer.    We hold and conclude that petitioner made no
                                - 14 -

economic outlay with respect to any part of the $800,000 “loan”

to Marc.11

IV.   Silver Glen Loan

      Petitioner argues that he has additional basis in Marc by

virtue of a $49,000 loan that he claims he previously made to

Silver Glen.    On opening brief, petitioner contends that in 1997

Silver Glen repaid this loan to him, and that he then contributed

the $49,000 to Marc, entitling him to basis of that amount in

Marc.12    Respondent disputes whether petitioner ever made a

$49,000 loan to Silver Glen, whether Silver Glen ever repaid such




      11
       Petitioner has not raised, and we do not reach, any issue
regarding the proper tax treatment of the $1,000 prepaid finance
charge that petitioner paid the Bank upon making his promissory
note.

     On brief, respondent argues that petitioner was not at risk
with respect to his purported $800,000 loan to Marc, and
therefore petitioner’s loss deductions from Marc are disallowed
pursuant to sec. 465(a). In light of our conclusion that the
$800,000 purported loan gave petitioner no basis in Marc, it is
unnecessary to reach the issue whether petitioner was at risk
with respect to the purported loan. We note, however, that “The
at risk analysis is very similar to the actual economic outlay
analysis”. Oren v. Commissioner, 357 F.3d 854, 859 (8th Cir.
2004), affg. T.C. Memo. 2002-172.
      12
       On reply brief petitioner alters his story to say that in
1997 Silver Glen “distributed this [$49,000] loan to Petitioner”
and “Petitioner contributed the * * * [Silver Glen] note to * * *
[Marc].” There is no such note in evidence. But under this
version of the facts, it is not apparent that the contribution to
Marc of such a Silver Glen note would create any basis in Marc;
by his own admission, petitioner had zero basis in the Silver
Glen note. In any event, petitioner’s inconstancy with respect
to the facts undermines his credibility.
                                - 15 -

a loan to petitioner, and whether petitioner ever contributed

$49,000 to Marc.

     The parties have stipulated that the books and records of

Silver Glen and Marc indicate that a $49,000 loan from petitioner

to Silver Glen was “reallocated” by adjusting journal entry from

Silver Glen to Marc, which then included this amount in its

“Loans to stockholders” account.     Petitioner has not introduced

any evidence, such as canceled checks or bank statements, to show

that he actually disbursed $49,000 of his own funds to Silver

Glen.     As previously indicated, mere adjusting journal entries

among petitioner’s wholly owned S corporations are inadequate to

establish that petitioner has made an actual economic outlay to

Marc.     Moreover, insofar as the record reveals, Marc’s purported

assumption of Silver Glen’s purported debt was not accompanied by

a novation releasing Silver Glen from liability to petitioner.

Accordingly, if Marc failed to pay the purported debt, petitioner

presumably would have had recourse against Silver Glen; the

continued existence of petitioner’s rights against Silver Glen

negates creation of basis in Marc with respect to the purported

debt.     See Hitchins v. Commissioner, 103 T.C. at 717-719.

        On his 1997 Federal income tax return, petitioner reported a

$49,000 long-term capital gain from “Recapture of Loan Basis”

with respect to the Silver Glen loan.     At most, this tax

reporting might tend to corroborate petitioner’s claim that
                                 - 16 -

Silver Glen repaid a $49,000 loan to him in which he had no

adjusted basis.     This tax reporting does not establish, however,

that petitioner made any economic outlay to Marc.

V.   Legal Expenses

      Petitioner claims that during 1997 he paid from his personal

assets more than $350,000 of Marc’s expenses.      He claims that he

has been able to locate substantiation for only $70,454 of these

expenses; accordingly, he claims basis in Marc for this amount.13

      Petitioner bears the burden of proving that he incurred the

claimed expenses, that they were paid to protect or enhance the

value of his investment in Marc, and that they were contributions

to Marc’s capital or loans to Marc.       Thomson v. Commissioner,

T.C. Memo. 1983-279, affd. without published opinion 731 F.2d 889

(11th Cir. 1984).     Although the record contains evidence that

legal bills aggregating $70,454 were paid during 1997, there is

no evidence that the legal bills were paid by petitioner or on

behalf of Marc.14     The parties have stipulated that the expenses

in question were “recorded by” Silver Glen and “reallocated by

adjusting journal entry” to Marc.     Petitioner has offered no



      13
       Petitioner concedes that he lacks the requisite proof for
the remainder of the alleged legal expenses and is therefore not
entitled to basis with respect thereto.
      14
       The invoices identify the matters involved only as
“Kaplan v. Brown” and “Philip Wolin Litigation”. The record
contains no explanation as to how such matters might relate to
Marc.
                                - 17 -

explanation as to why the expenses should have been recorded by

Silver Glen, if they were paid by petitioner personally on behalf

of Marc.   We conclude and hold that petitioner has failed to

prove that he is entitled to any basis in Marc with respect to

the alleged legal expense.

VI.   Conclusion

      Petitioner has failed to establish that as of December 31,

1997, he had adjusted basis in Marc greater than the $321,859

that respondent has conceded.    Accordingly, pursuant to section

1366(d), petitioner’s 1997 loss deductions from Marc are limited

to $321,859.   To reflect respondent’s concession,


                                             Decision will be

                                         entered under Rule 155.
