                        T.C. Memo. 2001-276



                      UNITED STATES TAX COURT



     FLINT INDUSTRIES, INC. AND SUBSIDIARIES, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 10645-97.            Filed October 10, 2001.



     Mark H. Allen, Kevin L. Kenworthy, and Frances F. Hillsman,

for petitioner.

     David G. Hendricks, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     MARVEL, Judge:   Respondent determined the following

deficiencies in the Federal income tax of Flint Industries, Inc.,

and subsidiaries:
                                    - 2 -

                FYE May 31                        Deficiency

                   1989                             $66,096
                   1990                             663,532
                   1991                           1,014,268
                   1992                             752,581

     Flint Industries, Inc., and subsidiaries, hereinafter

collectively referred to as petitioner, filed a petition to

redetermine the deficiencies.1       Following concessions, the issue

presented for decision is whether the following worthless stock

and bad debt deductions claimed by petitioner on its consolidated

Federal income tax returns for fiscal years ending (FYE) May 31,

1992, 1993, and 1994, are allowable under sections 165 and 166:2

    FYE May 31               Worthless stock           Bad debt

         1992                  $7,374,438             $6,564,124
         1993                   2,435,876                815,105
         1994                      –-                  6,085,248

     Respondent contends that petitioner’s worthless stock and

bad debt deductions must be disallowed because (1) the amounts

claimed as bad debts were capital in nature, and (2) petitioner

has failed to prove that the alleged bad debts and worthless



     1
      Petitioner reported net operating losses (NOLs) for fiscal
years ended 1992, 1993, and 1994 which it carried back to prior
years. Respondent’s adjustments reduced the NOLs available to be
carried back to prior years, resulting in the deficiencies
determined by respondent in the notice of deficiency.
     2
      All section references are to the Internal Revenue Code in
effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. Monetary amounts have
been rounded to the nearest dollar or deutsche mark as
appropriate.
                                - 3 -

stock were worthless in the taxable years the disputed deductions

were claimed.3    Respondent concedes, however, that all of the

disallowed worthless stock and bad debt deductions constitute a

long-term capital loss for FYE May 31, 1994.

                          FINDINGS OF FACT

      Some of the facts, and pertinent German law, have been

stipulated for purposes of these proceedings and are so found or

stated.   The stipulations are incorporated herein by this

reference.

I.   In General

      At the time the petition was filed, Flint Industries, Inc.

(Flint), was a corporation with its principal place of business

in Tulsa, Oklahoma.    For all relevant years, Flint was the common

parent of a group of affiliated corporations that filed a

consolidated corporate income tax return for each of the taxable

years at issue.4    For all relevant years, Flint used the accrual

method of accounting and a fiscal year ended May 31.


      3
      As a result of respondent’s determination that petitioner
was not entitled to the claimed bad debt deductions, respondent
made a corollary adjustment to petitioner’s interest income.
Respondent agrees that this adjustment will be resolved
consistent with our resolution of the bad debt issue. Petitioner
also alleges error in the computation of the deficiencies. The
parties agree that the computational matters will be addressed in
the Rule 155 computation.
      4
      In its reply brief, petitioner states that only Flint and
its domestic subsidiaries filed consolidated returns for the
years at issue; Günther, a foreign subsidiary, was not eligible
to be included, and was not included, in the consolidated group.
                                - 4 -

      During the years at issue, Flint was engaged primarily in

the business of large-scale construction and oil and gas

servicing.    Flint’s ability to conduct its business successfully

depended heavily upon Flint’s maintaining good banking and surety

relationships.

      In the late 1970s and early 1980s, Flint, directly or

through its subsidiaries, purchased three electronics companies,

one of which was W. Günther GmbH (Günther).     Günther was an

electronic component manufacturing firm located in Nürnberg,

Germany.    It was organized as a German Gesellschaft mit

beshrankter Haftung (GmbH) and was classified as a corporation

for U.S. tax purposes.    Günther used the accrual method of

accounting and a fiscal year ending on April 30.

II.   Petitioner’s Basis in Günther’s Stock

      Flint’s majority-owned subsidiary, Flint Electronics Co.

(Flint Electronics), purchased 100 percent of Günther’s stock for

$4,890,388 during FYE May 31, 1981.     During FYE May 31, 1985,

Flint Electronics contributed $484,050 to Günther’s capital.       As

set forth more fully, infra, during FYE May 31, 1992, Flint

Electronics contributed an additional $2 million to Günther’s

capital.5    As of May 31, 1992, Flint Electronics’ adjusted basis


      5
      Although the parties stipulated to these facts, several
exhibits in the case appear to contradict the facts regarding
ownership. For example, Günther’s commercial report for its FYE
April 30, 1991, the audited financial statement required by
                                                   (continued...)
                                   - 5 -

in its Günther stock, before taking into account the amounts at

issue in this case, was $7,374,438.

III.       Günther's Management and Operations

       Günther’s geschäftsführer, Albert Günther (Albert), and its

procurist, Hans Kampfrad (Kampfrad), controlled Günther’s day-to-

day management and operations.6      Albert reported directly to

Flint’s president.

       Most of Günther’s products were switches, relays, and sensor

devices such as those used for air bags and braking systems.       The

market for these products was highly cost-sensitive because

Günther had several competitors that made similar products.

       At some point before 1992, Günther was an industry leader in

air bag sensor technology.       Subsequently, however, new products

superseded Günther's technology and eroded its competitive

advantage.       Although Günther owned patents for some of its

manufacturing processes, by May 31, 1992, Günther's patents had


       5
      (...continued)
German law, states that Günther is a wholly owned subsidiary of
Gordos International Corp., and Günther’s commercial report for
its FYE April 30, 1992, states that Günther’s share capital was
transferred from Gordos International Corp. to Flint Electronics
Co. We accept the parties’ stipulation, however, because the
relevant facts regarding Günther’s ownership by a member of the
affiliated group and petitioner’s adjusted basis in Günther’s
stock are not in dispute.
       6
      The positions of geschäftsführer and procurist in a German
GmbH are similar to those of general manager and controller in a
U.S. company. However, because the geschäftsführer and procurist
were the only members of Günther’s senior management, they had
considerably more power and authority.
                                 - 6 -

little or no value because the underlying technology was widely

available in other forms.

IV.    Günther's Subsidiaries

       Günther was the majority owner of several subsidiaries that

manufactured or sold products in India, France, Switzerland, and

Germany (Berlin).     The French and Swiss subsidiaries were

distribution outlets that sold Günther's products.     The Berlin

subsidiary was essentially a manufacturing subcontractor for

Günther.    The Indian subsidiary began as a joint venture in 1991.

It operated a manufacturing facility that was supposed to produce

Günther’s products at a lower cost.      Günther’s subsidiaries were

valued at historical cost (book value) on Günther’s balance

sheet.     As of May 31, 1992, the subsidiaries’ book values

exceeded their fair market values.

V.    Flint’s Guaranties of Günther’s Bank Loans and Lease

       In the 1980s, Flint also provided some working capital to

Günther and guaranteed certain of Günther’s bank loans.      With one

exception discussed below, all of these guaranties were given

between 1983 and 1989.     During this period, Günther did not have

much equity, it had a poor relationship with German banks, and

its earnings were erratic.

       At some point before January 1992, without the knowledge or

approval of Flint’s management,7    Günther obtained a loan of


       7
        Although Flint had imposed restrictions on the authority of
                                                     (continued...)
                               - 7 -

roughly 2,500,000 deutsche marks (DM)8 from Bankhaus Reuschel

(Reuschel).9   In February 1992, when Reuschel indicated it would

demand immediate payment of the loan without Flint’s guaranty,

Flint guaranteed the loan.   Because Günther was operating at a

loss by then, Flint’s management knew that guaranteeing the

Reuschel loan was risky.   Still, Flint extended the guaranty, as

it saw no economically reasonable alternative short of advancing

Günther the cash to repay the note.

     Günther’s long-term liabilities also included a lease for

Günther’s building in Nürnberg.   This building was owned by

Actium Leasobjekt GmbH & Co. KG (Actium), a limited partnership.

Günther owned a 99-percent limited partnership interest in

Actium.   In the early 1980s, shortly after acquiring Günther,

Flint guaranteed the lease for Günther’s building in Nürnberg.

     Günther’s bank loans were listed on its balance sheets as

notes payable.   As of April 30, 1992, the principal balances of

Günther’s notes payable to banks totaled $10,976,220, and accrued


     7
      (...continued)
Günther’s management to enter into loans, those restrictions on
management's actual authority were unenforceable with regard to
third parties because managers of a German GmbH have statutory
authority to represent and bind the company in transactions with
third parties.
     8
      On average, 1 deutsche mark was worth approximately 60
cents during the years at issue.
     9
      Flint decided to terminate Albert at least partly because
of this transaction. The terms of his severance were being
negotiated when Flint discovered the Omega transaction (discussed
infra), at which point Albert was abruptly fired.
                               - 8 -

interest thereon totaled $1,382,965.   Günther also owed Actium

$4,942,343 under the terms of its lease.10

VI.   Petitioner’s Efforts To Sell Günther During 1987-1990

      In 1987, petitioner decided to focus on its core businesses

and began efforts to sell Günther and its other electronics

subsidiaries.   Petitioner engaged investment bankers in the

United States and in Germany to find potential buyers, and the

bankers endeavored to do so during 1988, 1989, and 1990.   As part

of the sales effort, petitioner and its agents contacted hundreds

of potential purchasers, and serious discussions were held with

more than 10 companies.

      In 1990, petitioner negotiated a letter of intent with a

potential purchaser, AMETEK, to sell Günther for DM 11 million.

The consideration included Flint's release from its guaranties of

Günther's bank loans.   In late 1990, however, AMETEK withdrew its

letter of intent for undisclosed reasons while conducting its due

diligence investigation.   This withdrawal coincided with rising

oil prices during the Gulf War and a general downturn in the

European auto industry, during which the electronics and

automotive industries suffered setbacks.




      10
      Günther’s liabilities were stated in deutsche marks. The
amounts in this paragraph have been converted to U.S. dollars
using an exchange rate of .6025.
                                - 9 -

VII.    Günther's Financial Demise

       As of FYE May 31, 1990, the income statement of Günther and

its subsidiaries showed a net profit of $387,962.    During FYE May

31, 1991, petitioner began advancing cash to Günther so that

Günther could service its bank loans and meet its short-term

financial obligations.    As of FYE May 31, 1991, the income

statement of Günther and its subsidiaries showed a net loss of

$414,443.

       Early in FYE May 31, 1992, Günther management's interim

reports to petitioner showed a fiscal-year-to-date loss of

roughly DM 5 million ($3,012,500 approximately).    From

petitioner’s perspective, this result was a disaster.      Günther

was unable to pay its bank loans and trade payables currently out

of cashflow generated from its operations, and, consequently,

petitioner had to advance the necessary funds to prevent a

default by Günther on the guaranteed bank loans.    Sometime later

in FYE May 31, 1992, Günther’s management reported that a capital

contribution in the amount of $2 million was required to avert

statutory bankruptcy under German law.    Petitioner made the

requested contribution to capital after Günther’s management

projected significant improvement in operating results for the

latter half of Günther’s FYE April 30, 1992.

       Petitioner’s management first became aware of the true

severity of Günther’s financial problems during July 1992, when
                               - 10 -

it discovered a transaction that would become known as the Omega

transaction.

      A.   The Omega Transaction and Petitioner's Discovery of
           Misleading Financial Reporting by Günther’s Management

     In the Omega transaction, Günther transferred machinery to

Omega-Reed GmbH (Omega), a no-asset corporation owned by one of

Günther’s former employees, in exchange for Omega’s promise to

produce switches for Günther at a reduced cost and for a promise

to pay in the future.    Despite Omega’s tenuous financial

condition, no security agreement was executed in connection with

the transfer.   In an apparent effort to hide Günther’s true

financial condition, Günther’s management originally reported a

profit of DM 2,900,000 on the Omega transaction and booked the

amount due as a receivable from Omega in Günther’s books and

records for FYE April 30, 1992.11   Any profit, however, was

contingent upon the receipt and sale of Omega products to

Günther's customers over a multiyear period, and thus was

extremely speculative.

     After petitioner discovered the Omega transaction in July

1992, Flint's president, Paul K. Lackey, Jr., dispatched senior

management to Germany immediately, and Mr. Lackey soon followed.


     11
      The alleged profit was backed out and recharacterized in
Günther’s commercial report for FYE April 30, 1992, and
litigation was filed to recover the machinery. Although Günther
eventually recovered at least some of its machinery, the
machinery had been stripped of its operating controls and
essentially was worthless by the time the machinery was
recovered.
                              - 11 -

Petitioner began to investigate Günther’s financial condition and

discovered that Günther’s management had concealed the magnitude

of Günther’s operating losses by capitalizing expenses into phony

inventory, incorrectly accounting for inventory, and overstating

receivables with Günther's subsidiaries.

     On August 20, 1992, Mr. Lackey fired Albert because, among

other reasons, petitioner had discovered that Albert had

orchestrated the coverup.   For a short time after Albert was

fired, Kampfrad acted as geschäftsführer, but, as Mr. Lackey

suspected that Kampfrad had been involved in the coverup, Mr.

Lackey eventually dismissed him as well.

      B.   Günther’s True Financial Condition as of FYE April 30,
           1992

     In addition to the investigation by petitioner’s management

discussed above, Günther’s German auditors conducted an audit in

connection with the preparation of Günther’s commercial report

for its FYE 1992.   Petitioner’s investigation revealed that

Günther’s liabilities substantially exceeded the book value of

its assets as of April 30, 1992, and that Günther was currently

unable to pay its bank loans and other liabilities.   The audit

revealed that, for its FYE 1992, Günther had incurred a net loss

from operations of DM 15,903,268 and that it had a “deficit not

covered by equity” of DM 4,068,076, determined under German

accounting standards.
                                 - 12 -

      C.     Bankruptcy Under German Law

     Under German bankruptcy law, the geschäftsführer of a GmbH

must file a bankruptcy proceeding, at the latest, within 3 weeks

of the GmbH’s becoming overindebted or insolvent.12      For purposes

of German bankruptcy law, a GmbH is overindebted when its

liabilities exceed its assets, and it is insolvent when it cannot

pay its immediately due debts on a permanent basis for the

foreseeable future.

     A GmbH’s bankruptcy allows its creditors to accelerate the

debts owed to each creditor and to pursue collection of

guaranteed debt from the guarantors.       In addition, a creditor of

an overindebted or insolvent GmbH is authorized to file for the

GmbH’s bankruptcy.

     If a shareholder of a bankrupt GmbH has made loans to, or

assumed other liabilities of, a bankrupt GmbH, including payments

of guaranteed debt, and the German bankruptcy court determines

that such loans, assumptions, or payments were made at a time

when the GmbH was overindebted or insolvent, the bankruptcy court

can deny the shareholder repayment of such amounts.      Within 1

year after bankruptcy proceedings are opened, the administrator

may challenge (1) any transaction by the bankrupt GmbH

prejudicing creditors that occurred within 6 months of the

beginning of the bankruptcy proceeding, if such transaction



     12
          Failure to do so is a criminal offense under German law.
                              - 13 -

occurred while the GmbH was overindebted or insolvent, or within

10 days prior to the GmbH’s becoming overindebted or insolvent,

and the other party to the transaction knew of such

overindebtedness or insolvency, and (2) any transaction by the

GmbH, regardless of when such transaction occurred, the purpose

or intent of which was to prejudice creditors, if such

transaction occurred at a time reasonably connected to a

subsequent bankruptcy.

     In order to avoid bankruptcy under German law, the owners of

a GmbH are required to endorse a plan aimed at improving the

GmbH’s financial stability as determined under applicable German

accounting principles.

      D.   Petitioner’s Evaluation of Günther’s Financial
           Condition

     Faced with Günther’s catastrophic net loss for FYE April 30,

1992, petitioner’s management considered its options with respect

to Günther.   It ascertained the fair market value of Günther’s

assets, looking for any asset whose fair market value so exceeded

its book value that the asset might be converted into cash to pay

down bank loans Flint had guaranteed.   It attempted to identify

any liabilities not reflected on Günther’s books that could arise

if Günther were sold or liquidated or if Günther were forced into

bankruptcy.   Most importantly, petitioner analyzed available

options in order to ascertain which option would result in the

smallest financial loss to petitioner from Günther’s financial
                                - 14 -

collapse.   As a result of this analysis, petitioner’s management

concluded that the option most likely to minimize petitioner’s

losses with respect to Günther was to prevent Günther’s

bankruptcy and any default on Günther’s bank loans while

petitioner paid down the guaranteed bank loans and attempted to

find a purchaser for Günther.

     Once petitioner’s management concluded that Günther was no

longer a viable going concern, that Günther must be sold or

otherwise disposed of, and that its disposal would generate a

loss, it presented its plan to petitioner’s board of directors.

On September 3, 1992, petitioner’s board of directors approved

the plan to dispose of Günther, and petitioner adopted

discontinued operations treatment with respect to Günther’s

operations in preparing petitioner’s consolidated financial

statements as of May 31, 1992.

      E.    Discontinued Operations Treatment

     Petitioner has prepared its consolidated financial statement

in accordance with U.S. Generally Accepted Accounting Principles

(U.S. GAAP) since 1981.    U.S. GAAP requires a company to treat a

business segment or unit as a discontinued operation when the

company makes a decision to dispose of the business segment or

unit and management expects to incur a loss on the disposal.

     When a company adopts discontinued operations treatment with

respect to a business unit, U.S. GAAP requires management to
                             - 15 -

assess the period of time operations will continue until disposal

and the expected results of operations over that time period.

U.S. GAAP also requires management to evaluate the expected

outcome from the disposal of the business unit.     In order to do

so, management is required to adjust the value of the unit’s

assets from book value to net realizable value.13

     After conducting a review of Günther’s assets and obtaining

appraisals where necessary, petitioner’s management concluded:

(1) The values of most of Günther’s book assets must be adjusted

downward to reflect that their net realizable values were lower

than their book values; (2) the value of Günther's ownership

interest in Actium must be adjusted upward to reflect its net

realizable value in excess of book value; and (3) Günther’s

liabilities substantially exceeded the fair market value of

Günther’s assets as of May 31, 1992.

     On its consolidated statement of operations and retained

earnings for FYE May 31, 1992, petitioner reported a loss from


     13
      For Federal estate, gift, and income tax purposes, fair
market value means “the price at which the property would change
hands between a willing buyer and a willing seller, neither being
under any compulsion to buy or to sell and both having reasonable
knowledge of relevant facts.” United States v. Cartwright, 411
U.S. 546, 551 (1973); Martin Ice Cream Co. v. Commissioner, 110
T.C. 189, 220 (1998). Although net realizable value is an
accounting concept which apparently refers to the net value
realizable from the sale or disposition of a business unit and/or
its assets and is not necessarily the same as fair market value,
we are satisfied that petitioner’s management calculated the fair
market value of Günther’s assets and that those values were
considered in determining the net realizable value of Günther’s
assets for financial statement purposes.
                              - 16 -

discontinued operations, attributable to Günther, of $13,496,553

before income taxes.   After reducing the loss for an income tax

benefit of $4,229,613, petitioner reported a net loss

attributable to Günther of $9,266,940.   On its consolidated

balance sheet for FYE May 31, 1992, petitioner reported a net

liability from discontinued operations attributable to Günther of

$10,502,000, consisting of a projected loss during the phaseout

period of $3,883,000 and a projected loss on the final sale of

Günther’s assets of $6,619,000.

      F.   The Intercompany Account

     Flint and its subsidiaries used an intercompany account to

record various charges and credits among the different companies.

Intercompany account balances were recorded in the books and

records of the companies as accounts receivable/payable and

accrued interest at a market rate.

     Günther’s intercompany account balance during the years at

issue consisted of the following components:   (a) Corporate

charges; (b) interest charges; (c) allocations of expenses

incurred on a group basis for Flint and its subsidiaries; e.g.,

insurance; (d) intercompany purchases; and (e) cash advances;

i.e., cash paid directly to banks or advanced to Günther for that

purpose and cash advanced to Günther for the purpose of meeting

other short-term financial obligations, such as payroll.   The

following table shows Günther’s intercompany account balances for
                                                       - 17 -

         the FYE May 31, 1981-94,14 the composition of Günther’s

         intercompany account balances for the FYE May 31, 1991-94, the

         amount of Günther’s bank loans assumed by petitioner during FYE

         May 31, 1994, and certain waivers of intercompany account

         balances discussed, infra.

                                                                        Balance                   Balance
                                                                         owed                     owed by
                                                                        by (to)      Waivers       (to)
                                     Group                              Günther        of         Günther       Bank
Fiscal     Corporate   Interest     expense    Interco.       Cash      before      Interco.       after        debt
 year        charge      charge   allocation   purchases    advances    waivers      balance      waivers    assumption


1981         ---         ---         ---         ---          ---      $836,430        ---          ---         ---

1982         ---         ---         ---         ---          ---      1,476,550       ---          ---         ---

1983         ---         ---         ---         ---          ---      1,129,649       ---          ---         ---

1984         ---         ---         ---         ---          ---       747,695        ---          ---         ---

1985         ---         ---         ---         ---          ---        31,830        ---          ---         ---

1986         ---         ---         ---         ---          ---        (9,787)       ---          ---         ---

1987         ---         ---         ---         ---          ---      (431,874)       ---          ---         ---

1988         ---         ---         ---         ---          ---      (104,906)       ---          ---         ---

1989         ---         ---         ---         ---          ---       434,349        ---          ---         ---

1990         ---         ---         ---         ---          ---       (91,019)       ---          ---         ---

1991      $180,000     $36,992    $130,327     $341,436    $650,000    1,247,736       ---          ---         ---

1992       180,000     275,006      26,178      564,736    4,270,468   6,564,124       ---          ---         ---

1993       180,000     184,366      51,792       ---       2,834,823   9,815,105   ($9,000,000)   $815,105      ---

1994        50,000      58,635      23,570       ---       2,243,583   3,190,893   (2,429,665)    761,228    $3,709,460


                Günther made no payments on its intercompany account balance

         during FYE May 31, 1992, 1993, or 1994.                       Petitioner did not

         expect advances it made to Günther or on Günther’s behalf during

         FYE May 31, 1992, 1993, and 1994 to be repaid.




                14
               The record does not reflect the specific charges before
         FYE May 31, 1991.
                                 - 18 -

       G.    Petitioner’s Plan To Dispose of Günther

       Günther’s financial condition as of May 31, 1992, was so bad

that petitioner could have forced Günther to file for bankruptcy

simply by withholding additional financial support.     Petitioner

discussed bankruptcy but decided to pursue an orderly disposition

of Günther to minimize petitioner’s losses from Günther’s

financial collapse and to avoid triggering contingent and/or

potential liabilities, which did not appear on Günther’s balance

sheet.      The plan included making payments on the guaranteed bank

loans to prevent Günther’s default until a purchaser could be

found, shoring up Günther’s German balance sheet by waiving

petitioner’s right to collect a portion of Günther’s intercompany

account balance, and minimizing petitioner’s exposure on the

lease guaranty by purchasing Günther's interest in Actium.

             1.   The First Waiver Subject to Reinstatement

       Under German GmbH law, a formal contribution to the capital

of a GmbH by its owner requires an amendment to the GmbH’s

charter, which must be effected in accordance with German GmbH

law.    An informal contribution to a German GmbH, however, does

not require a charter amendment.     One type of informal

shareholder financing available to a German GmbH is a waiver of a

shareholder’s loan to the GmbH.

       A waiver of a shareholder's loan subject to reinstatement is

a form of contingent debt that can return a subsidiary GmbH to
                               - 19 -

technical solvency for German law purposes.    A waiver of a

shareholder’s loan to a GmbH can be made subject to the condition

that the loan will be reinstated as soon as the financial

condition of the subsidiary GmbH has improved to permit repayment

out of surplus capital.   When a waiver subject to reinstatement

is given, interest for the period of time during which the loan

had been waived can be imposed upon the subsidiary GmbH.

     As part of its plan to dispose of Günther and in order to

forestall the filing of a bankruptcy proceeding with respect to

Günther, petitioner waived portions of Günther’s intercompany

account balance.

     The first waiver, executed on October 1, 1992, involved

several steps.   First, Flint assigned $9 million of Günther’s

intercompany account balance to Flint Electronics.    Next, Flint

Electronics formally waived the receivable “In order to create a

sound financial basis for future operations * * * and to

recapitalize Günther”.    The waiver was subject to the condition

that “at such time that the net equity of Günther exceeds its

registered capital * * * the waived amount will * * * [at Flint

Electronic’s option] be owed by Günther again”.    Flint

Electronics recorded the waived intercompany receivable as

contributed capital.   This first waiver effectively reclassified

$9 million of the intercompany account payable on Günther’s books
                                - 20 -

as equity, thereby enabling Günther to issue its FYE April 30,

1992, commercial report and avoid statutory bankruptcy.15

          2.    The Actium Transaction

     The next part of petitioner’s plan to minimize its exposure

involved the purchase of Günther's interest in Actium.    Unlike

virtually every other asset on Günther’s German balance sheet,

the fair market value of Günther’s partnership interest in Actium

exceeded its book value.   Petitioner concluded that if Günther

were to sell its interest in Actium to an affiliated company, the

resulting net cashflow could be used to pay down Günther’s

liabilities, while minimizing petitioner’s potential exposure in

the event of Günther’s bankruptcy.

     Petitioner organized a subsidiary, Investors Capital Company

(ICC), which purchased Günther’s ownership interest in Actium in

December 1992 for its fair market value of approximately

$3,477,000.    The fair market value of Günther’s interest in

Actium was determined by an independent third-party appraisal

because petitioner was concerned that the transaction could be

reversed in bankruptcy.    The purchase yielded a positive cashflow

to Günther of DM 8,000,000.16

     15
      Günther’s auditors would not issue financial statements
for FYE Apr. 30, 1992, that showed liabilities in excess of
assets, one of the conditions resulting in statutory bankruptcy.
     16
      The return of a related sinking fund and an amount
attributable to tenant improvements increased the funds available
to pay down Günther’s liabilities from approximately DM 5,400,000
                                                   (continued...)
                              - 21 -

     To ensure that all of Günther’s creditors benefited from the

Actium sale, Flint directed Günther to use 80 percent of the cash

generated by the Actium sale to pay down Günther’s guaranteed

bank loans in proportion to their balances.     The remaining cash

was used to pay employee salaries, trade creditors, and tenant

improvements.   None of the sale proceeds were used to repay any

part of the intercompany account balance owed by Günther to

petitioner.

      H.   Petitioner’s Efforts To Dispose of Günther

     Throughout the period following discovery of the Omega

transaction and dismissal of Günther's management, petitioner

continued Günther’s operations while seeking potential purchasers

for Günther and its product lines.     Petitioner retained

investment banks and brokers, but there was very little interest

in Günther.   Before the purchase of Günther by Günther America,

Inc. (GAI), during FYE May 31, 1994, discussed infra, only one

offer to purchase Günther was received.     In March 1993, Celduc,

one of Günther's principal competitors, offered to purchase

Günther, if petitioner contributed cash of DM 20 million

(approximately $12,050,000) and made guaranties and concessions

worth several million dollars more.     After unsuccessful efforts

to negotiate a more favorable deal, petitioner ultimately



     16
      (...continued)
to approximately DM 8 million.
                              - 22 -

rejected Celduc's offer and continued to seek other potential

purchasers.

     Generally, from July 1992 forward, one of petitioner's board

members or corporate officers was onsite in Germany to supervise

Günther’s management and keep petitioner informed of

developments.   Despite petitioner’s supervision, Günther

continued to report operating losses in FYE April 30, 1993 and

1994.

     In March 1993, petitioner hired Elson Nowell as

geschäftsführer.   Upon becoming geschäftsführer, Mr. Nowell

discovered that Günther had inflated the value of its inventory

by cycling old inventory through its subsidiaries.17   This

discovery necessitated additional substantial writeoffs in

connection with the preparation of Günther’s commercial report

for its FYE April 30, 1993.

     On January 21, 1994, in order to make Günther more appealing

to potential purchasers, petitioner arranged an additional waiver

of Günther’s intercompany receivable.   Flint assigned $2,429,665

of its intercompany receivable to Flint Electronics, which then

waived the receivable, subject to reinstatement.   This second

waiver was identical in all practical aspects to the first


     17
      Under accounting principles applicable to an electronics
firm such as Günther, older inventory is written down to
progressively lower values to account for its obsolescence and
reduced market value. Günther avoided this writedown by
transferring assets among the subsidiaries.
                             - 23 -

waiver, and was made "to create a sound financial basis for

future operations * * * and to recapitalize Günther."

     Sometime between January and April 1994, petitioner finally

found a purchaser for Günther.   Robert P. Romano, an individual

who had worked for one of Flint's other electronics subsidiaries

and had started an electronics company of his own, agreed to

purchase Günther through GAI, a corporation formed to acquire

Günther.

     Under the terms of a sale agreement dated April 13, 1994,

GAI gave Flint Electronics a promissory note for DM 5,000,000,

Flint assumed all of Günther's remaining bank debt ($3,709,460)

and forgave the remaining intercompany receivable balance

($761,228), and Flint Electronics relinquished its right to

reinstate the waived intercompany receivable ($11,429,665).

GAI’s promissory note provided for minimum principal and interest

payments beginning in FYE May 31, 1996, and specified that the

payment schedule would accelerate if GAI sold assets other than

in the ordinary course of business or became profitable.

Petitioner bargained for the note to discourage GAI from

liquidating Günther.

     GAI retained Mr. Nowell as geschäftsführer.   In the years

following the sale of Günther, the company reported a small

operating loss followed by marginal profits.   In 1996, the first

year payment under the promissory note became due, GAI/Günther
                                - 24 -

paid approximately DM 125,000 to one of Flint’s subsidiaries

pursuant to the promissory note.

VIII.     Günther’s Value as of May 31, 1992

        As of May 31, 1992, Günther's liabilities (excluding the

intercompany account payable of $6,564,124 owed to Flint and the

reserve for Günther’s projected FYE April 30, 1993, operating

loss of $3.2 million) exceeded the fair market value of its

assets by at least $7 million.     As of May 31, 1992, and for the

foreseeable future, Günther was unable to pay its guaranteed bank

loans and other obligations when due.

IX.     Deductions Claimed

        For FYE May 31, 1992, petitioner claimed a worthless stock

deduction of $7,374,438 (petitioner’s adjusted basis in Günther’s

stock without regard to our discussion herein) under section 165

and a bad debt deduction of $6,564,124 (the intercompany account

balance as of May 31, 1992) under section 166.

        For FYE May 31, 1993, petitioner claimed an additional

worthless stock deduction of $2,435,876 and a bad debt deduction

of $815,105.     The worthless stock deduction equaled the amount of

the first waiver subject to reinstatement, less the amount

claimed as a bad debt deduction on petitioner’s FYE 1992 return.

The bad debt deduction equaled the intercompany account balance

as of May 31, 1993.
                                 - 25 -

      For FYE May 31, 1994, petitioner reduced its income by

$6,085,248.18     This amount consisted of the ending balance of

Günther’s intercompany account as of May 31, 1994, that had not

yet been written off for Federal income tax purposes ($2,375,788)

and the amount of Günther’s guaranteed bank loans petitioner

assumed ($3,709,460).

X.   Notice of Deficiency

      In the notice of deficiency, respondent disallowed

petitioner’s deductions for bad debts and worthless stock

attributable to Günther that were claimed for FYE May 31, 1992

and 1993, increased petitioner’s income for FYE May 31, 1994, and

reduced petitioner’s net operating losses for FYE 1992, 1993, and

1994, accordingly.      Respondent recharacterized the disallowed

deductions as long-term capital losses and recomputed the net

operating loss carrybacks allowable for FYE 1989, 1990, 1991, and

1992.      Respondent also determined that other adjustments were

required, which have since been resolved by agreement or are

computational.




      18
      In the notice of deficiency, respondent proposed an
adjustment increasing petitioner’s income by $6,085,248. For
briefing and argument purposes, however, the parties have treated
the disputed adjustment as the disallowance of a bad debt
deduction.
                              - 26 -

                              OPINION

I.   Bad Debt Deductions

     Section 166 authorizes a taxpayer to deduct any debt that

becomes worthless within the taxable year.   Nonbusiness bad debts

are treated as losses resulting from the sale or exchange of a

short-term capital asset.   Secs. 166(d)(1), 1211(b), 1212(b).

Business bad debts are deductible as ordinary losses to the

extent of the taxpayer’s adjusted basis in the debt.   Sec.

166(b).

     In order for petitioner to prevail on the bad debt issue,

petitioner must first establish that:   (1) A bona fide debt

existed between petitioner and Günther which obligated Günther,

the alleged debtor, to pay petitioner a fixed or determinable sum

of money; (2) the debt was created or acquired in, or in

connection with, petitioner’s trade or business; and (3) the debt

became worthless in the year the bad debt deduction was claimed.

Sec. 166; United States v. Generes, 405 U.S. 93 (1972); Calumet

Indus., Inc. v. Commissioner, 95 T.C. 257, 284-285 (1990); Beaver

v. Commissioner, 55 T.C. 85, 91 (1970); Black v. Commissioner, 52

T.C. 147, 151 (1969).   A gift or contribution to capital is not

debt within the meaning of section 166.   Calumet Indus., Inc. v.

Commissioner, supra at 284; Kean v. Commissioner, 91 T.C. 575,

594 (1988).   Petitioner bears the burden of proving that it is
                                - 27 -

entitled to a business bad debt deduction under section 166.

Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).19

     Petitioner contends it properly deducted the intercompany

account balances owed to it by Günther as business bad debts

under section 166.    Respondent disagrees, contending that the

amounts constituting the intercompany account balances

(hereinafter collectively referred to as advances) were

contributions to the capital of Günther and that, even if the

advances qualify as bona fide debt, the debts were not worthless

in the years the deductions were claimed.

     A.   Were the Advances Made to Günther and Charged to the
          Intercompany Account Bona Fide Debt?

          1.   In General

     In order for us to find that a bona fide debt was created

for purposes of section 166, petitioner must prove that there was

“a genuine intention to create a debt, with a reasonable

expectation of repayment” and that the intention was consistent

with the “economic reality of creating a debtor-creditor

relationship”.     Litton Bus. Sys., Inc. v. Commissioner, 61 T.C.

367, 377 (1973).    Whether the requisite intention to create a

true debtor-creditor relationship existed is a question of fact

to be determined from a review of all the evidence.     Id.   Factors


     19
      The burden of proof provisions of sec. 7491 do not apply
here because the examination in this case began before July 22,
1998. See Internal Revenue Service Restructuring & Reform Act of
1998, Pub. L. 105-206, sec. 3001, 112 Stat. 726.
                              - 28 -

we ordinarily consider in our analysis include, but are not

limited to:   (1) The name given to the certificate evidencing the

indebtedness, (2) the presence or absence of a fixed maturity

date, (3) the source of payments, (4) the right to enforce

repayment, (5) any increase in management participation as a

result of the advances, (6) the status of the advances in

relation to debts owed to regular corporate creditors, (7) the

intent of the parties, (8) thin or adequate capitalization, (9)

the identity of interest between creditor and stockholder, (10)

payment of interest only out of profits, (11) the ability to

obtain loans from outside lending institutions, (12) the extent

to which the advance was used to acquire capital assets, and (13)

the failure of the corporation to repay on the due date.     Am.

Offshore, Inc. v. Commissioner, 97 T.C. 579, 602-606 (1991); see

also Calumet Indus., Inc. v. Commissioner, supra at 285; Anchor

Natl. Life Ins. Co. v. Commissioner, 93 T.C. 382, 400 (1989) (11

factors); Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493

(1980) (13 factors).   No single factor is determinative, and not

all factors are applicable in each case.   Dixie Dairies Corp. v.

Commissioner, supra at 493-494.   “The various factors * * * are

only aids in answering the ultimate question whether the

investment, analyzed in terms of its economic reality,

constitutes risk capital entirely subject to the fortunes of the

corporate venture or represents a strict debtor-creditor
                               - 29 -

relationship.”   Fin Hay Realty Co. v. United States, 398 F.2d

694, 697 (3d Cir. 1968).

     Before we apply the factors, however, we must first identify

the relevant date that governs our analysis.   Ordinarily we must

examine an advance as of the date it is made to decide whether it

qualifies as bona fide debt.   When an advance takes the form of a

payment required by a guaranty, however, we must examine the

circumstances existing on the date the guaranty is given.   Sec.

1.166-9(c), Income Tax Regs.   Petitioner contends that we must

divide the amounts recorded in the intercompany account into two

categories–-amounts reducing Günther’s guaranteed bank loan

balances and amounts paid on other obligations.   Petitioner

asserts that all amounts paid towards the bank loans were

payments required by Flint’s guaranties and must be analyzed as

of the dates of the guaranties.   Respondent contends that none of

the payments applied to Günther’s bank loans were payments that

Flint was required to make under its guaranties, and that all of

the advances, including those applied to the guaranteed bank

loans, must therefore be analyzed as of the dates the payments

were made.

     Petitioner did not prove that any of the banks declared a

default on any of Günther’s guaranteed bank loans or demanded

that petitioner pay under the guaranties, or that petitioner

actually made guaranty payments and, if so, in what amount.    We
                                - 30 -

conclude, therefore, that because petitioner has failed to prove

that any of the payments charged to the intercompany account were

guaranty payments, for purposes of our analysis under section 166

we must evaluate all of the advances constituting Günther’s

intercompany account balance as of the years the advances were

paid and recorded in the intercompany account.

         2.   Applying the Factors

     We proceed to examine the advances under the traditional

multifactor approach.    Cf. Hayutin v. Commissioner, 508 F.2d 462,

472-474 (10th Cir. 1974), affg. T.C. Memo. 1972-127.

Respondent’s determination as to whether a shareholder’s advance

is debt or equity is presumed to be correct.     Gooding Amusement

Co. v. Commissioner, 23 T.C. 408, 421 (1954), affd. 236 F.2d 159

(6th Cir. 1956).

              a.    Name Given to Certificate

     The advances in question were not memorialized by any

promissory note or other documentation characterizing the

advances as debt.    Consequently, both parties agree that this

factor is not relevant to our analysis.

              b.    Presence or Absence of Fixed Maturity Date

     “The presence of a fixed maturity date indicates a fixed

obligation to repay, a characteristic of a debt obligation.      The

absence of the same on the other hand would indicate that

repayment was in some way tied to the fortunes of the business,
                               - 31 -

indicative of an equity advance.”    Estate of Mixon v. United

States, 464 F.2d 394, 404 (5th Cir. 1972); see also sec.

385(b)(1); Am. Offshore, Inc. v. Commissioner, supra at 602.

Evidence that a creditor did not intend to enforce payment or was

indifferent as to the exact time the advance was to be repaid

belies an arm’s-length debtor-creditor relationship.    See

generally Gooding Amusement Co. v. Commissioner, supra at 418-

421.

       Petitioner acknowledges that there was no fixed date for

Günther’s repayment of petitioner’s advances but argues that the

history of repayment before FYE May 31, 1991, demonstrates that a

fixed repayment schedule was unnecessary.    Petitioner also

contends, but did not prove, that all members of the consolidated

group used the intercompany account in the same manner, and,

thus, this factor should not favor equity.

       The record in this case establishes that the intercompany

account was an open account with a running balance and no fixed

date for repayment.    While Flint and its subsidiaries may have

used the account in a similar fashion, any similarity in usage

does not change the fact that petitioner did not prove there was

any deadline for repayment of balances owed among the companies.

       This factor favors respondent’s position.
                              - 32 -

        c.   Source of the Payments

     If the source of the debtor’s repayment is contingent upon

earnings or is from a restricted source, such as a judgment

recovery, dividends, or profits, an equity investment is

indicated.   Estate of Mixon v. United States, supra at 405;

Calumet Indus., Inc. v. Commissioner, 95 T.C. at 287-288; Dixie

Dairies Corp. v. Commissioner, 74 T.C. at 495.     In such a case,

the lender acts “‘as a classic capital investor hoping to make a

profit, not as a creditor expecting to be repaid regardless of

the company’s success or failure.’”     Calumet Indus., Inc. v.

Commissioner, supra at 287-288 (quoting In re Larson, 862 F.2d

112, 117 (7th Cir. 1988)).   When circumstances make it impossible

to estimate when an advance will be repaid because repayment is

contingent upon future profits or repayment is subject to a

condition precedent, or where a condition may terminate or

suspend the obligation to repay, an equity investment is

indicated.   Affiliated Research, Inc. v. United States, 173 Ct.

Cl. 338, 351 F.2d 646, 648 (1965).

     Petitioner acknowledges that repayment of the advances was

dependent upon Günther’s earnings.     Therefore, the only question

is the weight to be given this factor.    We conclude that this

factor favors respondent’s position and that it is entitled to

considerable weight because Günther had no available source of

repayment other than its earnings and, during the years the
                                - 33 -

advances were made, petitioner knew there was very little, if

any, possibility that the advances would ever be repaid.20

              d.   The Right To Enforce Repayment

     A right to enforce the repayment of amounts advanced to

another, which is conferred on the entity making the advances, is

indicative of bona fide debt.    Estate of Mixon v. United States,

supra at 405; Am. Offshore, Inc. v. Commissioner, 97 T.C. at 603.

Petitioner failed to introduce any evidence regarding the

operation of the intercompany account in FYE May 31, 1991,21 and

thereafter or the terms applicable to any account balance, other

than with respect to interest.    Because petitioner bears the

burden of proof, petitioner’s failure to introduce evidence

regarding this factor weighs against petitioner’s position.

              e.   Increase in Management Participation

     If a creditor receives a right to participate in the

management of a business in consideration for an advance to the

business, such participation tends to demonstrate that the

advance was not a bona fide debt but rather was an equity

investment.   Am. Offshore, Inc. v. Commissioner, supra at 603.


     20
      Even the advances made during FYE May 31, 1991, were made
at a time when Günther had suffered a downturn in its business,
and repayment was dependent on earnings.
     21
      The intercompany account balance owed by Günther as of May
31, 1992, consisted, in part, of amounts advanced during FYE May
31, 1991. Unless otherwise noted, our analysis covers advances
in FYE May 31, 1991, as well as those in later years.
                              - 34 -

     Before petitioner learned of Günther’s dire financial

condition, Günther’s local management ran its day-to-day

operations with oversight from petitioner.   After petitioner

learned of Günther’s financial problems, petitioner’s management

became more actively involved in Günther’s operations, eventually

assuming direct control.   Although respondent argues that this

factor favors equity, we reject the argument.    Petitioner did not

receive an increased role in Günther’s management during FYE

1992, 1993, and 1994 in exchange for petitioner’s advances;

rather, petitioner’s increased participation in management was a

necessary part of its effort to prevent Günther’s financial

collapse from becoming public.   This factor is neutral.

             f.   Status Equal or Inferior to Other Creditors

     Whether an advance is subordinated to regular creditors

bears on whether the taxpayer was acting as a creditor or an

investor.   Estate of Mixon v. United States, supra at 406.     In

addition, “Failure to demand timely repayment effectively

subordinates the intercompany debt to the rights of other

creditors who receive payment in the interim.”     Am. Offshore,

Inc. v. Commissioner, supra at 603 (citing Inductotherm Indus.,

Inc. v. Commissioner, T.C. Memo. 1984-281, affd. without

published opinion 770 F.2d 1071 (3d Cir. 1985)).

     Petitioner effectively subordinated its intercompany

advances to Günther for the benefit of third-party creditors in
                                - 35 -

two ways.   First, petitioner caused Günther to distribute the net

proceeds from the Actium transaction as part payment to the banks

and trade creditors to whom Günther was liable, but no part of

the proceeds was used to repay the intercompany account balance.

Second, when petitioner waived portions of Günther’s intercompany

account balance, it effectively subordinated the intercompany

account balance to other creditors.

     Subordination of the advances strongly indicates equity.

This factor favors respondent’s position.

             g.     Intent of the Parties

     “[T]he inquiry of a court in resolving the debt-equity issue

is primarily directed at ascertaining the intent of the parties”.

A.R. Lantz Co. v. United States, 424 F.2d 1330, 1333 (9th Cir.

1970) (citing Taft v. Commissioner, 314 F.2d 620 (9th Cir. 1963),

affg. in part and revg. in part T.C. Memo. 1961-230).    Before the

waivers of portions of the intercompany account balance owed to

petitioner by Günther, both companies treated the intercompany

account balance as debt in that the outstanding account balance

accrued interest.    The intercompany account balance was recorded

as an account payable by Günther and an account receivable by

petitioner on their respective financial statements.

     Although petitioner treated the intercompany account balance

as debt on its books and records and referred to the account

balance as a debt owed to it by Günther, it is obvious that
                                - 36 -

neither petitioner nor Günther intended, or reasonably could have

intended, the advances22 to be bona fide debt.    Petitioner made

the advances to keep Günther from defaulting on its bank loans

and other obligations.    During FYE May 31, 1991 and 1992,

petitioner knew the advances were risky but made them anyway.

During FYE May 31, 1993 and 1994, petitioner realized that it

would not recover any of the amounts it had advanced to Günther

or for Günther’s benefit, and it continued to inject funds into

Günther for the sole purpose of minimizing the losses it would

incur before Günther’s disposal.    We conclude, therefore, that

neither petitioner nor Günther genuinely intended the advances to

be bona fide debt or reasonably expected the advances to be

repaid.   See Sigmon v. Commissioner, T.C. Memo. 1988-377.

     This factor favors respondent’s position.

             h.   Thin or Adequate Capitalization

     Inadequate or “thin” capitalization is strong evidence of a

capital contribution where:    (1) The debt-to-equity ratio was

initially high; (2) the parties realized that it would likely go

higher; and (3) substantial portions of these funds were used for

the purchase of capital assets and for meeting expenses needed to

commence operations.     Am. Offshore, Inc. v. Commissioner, supra



     22
      Even the advances charged to the intercompany account
during FYE May 31, 1991, were made to prevent a default on
Günther’s bank loans and to provide working capital.
                                - 37 -

at 604 (citing United States v. Henderson, 375 F.2d 36, 40 (5th

Cir. 1967)).

        In its reply brief, petitioner maintains that Günther had a

debt-to-equity ratio of 3.4:1 as of May 31, 1991.23    Petitioner

did not explain precisely how it calculated the debt-to-equity

ratio, nor did petitioner present any argument regarding the

proper method for calculating the ratio.24    Petitioner also

failed to explain why the debt-to-equity ratio it calculated as

of May 31, 1991, supported its position that Günther was

adequately capitalized during each of the taxable years at issue

here.

     The failures identified above, combined with our review of

evidence in the record, lead us to conclude petitioner has failed

to prove that the capitalization of Günther was adequate to meet

its reasonably foreseeable business needs.    There is certainly

ample evidence in the record from which an inference can be drawn

that Günther’s capitalization was inadequate.    Petitioner’s large


        23
      Petitioner apparently calculated the ratio by dividing
Günther’s total long-term liabilities of $4,782,637 as of May 31,
1991, by total stockholder’s investment of $1,405,422.
Petitioner’s method of calculating the debt-to-equity ratio
ignores approximately 80 percent of the total liabilities
outstanding as of May 31, 1991, and determines Günther’s equity
based upon the book value of Günther’s assets.
        24
      For example, in some cases, courts, including this Court,
have used the fair market values of assets rather than their book
values to calculate debt-to-equity ratios. E.g., Kraft Foods Co.
v. Commissioner, 232 F.2d 118 (2d Cir. 1956), revg. 21 T.C. 513
(1954); Mason-Dixon Sand & Gravel Co. v. Commissioner, T.C. Memo.
1961-259.
                                 - 38 -

cash infusions and Günther’s poor relationship with German banks

suggest inadequate capitalization.        Although petitioner’s capital

contributions to Günther in FYE May 31, 1985 and 1992, were

substantial, they were insufficient to staunch the flow of red

ink caused by Günther’s negative cashflow.

     For all relevant time periods, therefore, we conclude that

this factor favors respondent’s position.

               i.   The Identity of Interest Between Creditor
                    and Shareholder

     At all relevant times, a member of the consolidated group

was Günther’s sole shareholder.     Advances made by a sole

shareholder are more likely to be committed to the risk of the

business (and hence indicative of an equity investment) than are

advances made by creditors who are not shareholders of the

corporation.    Ga. Pac. Corp. v. Commissioner, 63 T.C. 790, 797

(1975).   The sole shareholder is also less likely to be concerned

than a third party would be with the safeguards normally used to

protect such advances.     Id.   Petitioner’s status as sole

shareholder obviously leads to an identity of interest which,

respondent argues, strongly indicates an equity investment.

Petitioner argues that its greater involvement in Günther’s day-

to-day management after Günther’s financial difficulties became

apparent shows that it was more interested in protecting its

interests as a creditor; i.e., its focus was on minimizing its
                                - 39 -

liability under the guaranties and not on protecting its equity

investment in Günther.

      The record in this case establishes that there was an

identity of interest between petitioner’s role as creditor and as

shareholder.    This factor favors respondent’s position.

               j.   Payment of Interest Only Out of Profits

     This factor is essentially the same as the third factor, the

source of the payments.     Hardman v. United States, 827 F.2d 1409,

1414 (9th Cir. 1987).    It focuses, however, on how the parties to

the advances treated interest.    As we have stated, “A true lender

is concerned with interest.”     Id. at 605 (citing Estate of Mixon

v. United States, 464 F.2d at 409).      The failure to insist on

interest payments indicates that the payors expect to be paid out

of future earnings or through the increased market value of their

equity interest.     Am. Offshore, Inc. v. Commissioner, supra at

605 (citing Curry v. United States, 396 F.2d 630, 634 (5th Cir.

1968)).

     Although the intercompany account balance accrued interest,

which was added to the yearend account balance reflected in the

books and records of both petitioner and Günther, Günther did

not, and financially could not, make any interest payments during

FYE May 31, 1992, 1993, or 1994.    Payment of the accrued interest

was entirely dependent on profits that Günther did not have and
                                - 40 -

was not likely to have in the future.    On balance, this factor

favors respondent’s position.

               k.   Ability of Günther To Obtain Funds From
                    Outside Lending Institutions

     “[T]he touchstone of economic reality is whether an outside

lender would have made the payments in the same form and on the

same terms.”    Segel v. Commissioner, 89 T.C. 816, 828 (1987)

(citing Scriptomatic, Inc. v. United States, 555 F.2d 364, 367

(3d Cir. 1977)); see also Calumet Indus., Inc. v. Commissioner,

95 T.C. at 287.

     The record contains only vague and limited information on

Günther’s financial status before FYE May 31, 1992, and no

evidence tending to prove that Günther could have obtained

comparable loans from unrelated financial institutions.       The

limited evidence regarding Günther’s financial condition before

FYE May 31, 1992, tends to show that Günther was not in a

position to obtain substantial funding from any financial

institution without meaningful security, guaranties from a third

party, and fixed payment terms.    Petitioner’s financial support

of Günther through the mechanism of the intercompany account had

none of these characteristics and was far more speculative.         See

Fin Hay Realty Co. v. United States, 398 F.2d at 697; Dixie

Dairies Corp. v. Commissioner, 74 T.C. at 497.

     This factor favors respondent’s position.
                                - 41 -


               l.   The Extent To Which the Advances Were Used
                    To Acquire Capital Assets

     Respondent concedes that the advances to Günther were used

primarily to service existing bank loans and that, therefore,

this factor is not relevant.

               m.   Failure To Repay on the Due Date

     Petitioner’s advances to Günther were made pursuant to an

open account arrangement with no fixed date for repayment.

Consequently, this factor is not relevant to our analysis.

          3.   Conclusion

     Upon consideration of the above factors, we hold that

Günther’s intercompany account balance during and after FYE May

31, 1992, was not a bona fide debt within the meaning of section

16625 and that petitioner is not entitled to the bad debt

deductions it claimed under section 166.    We treat the advances

recorded in the intercompany account, instead, as capital

contributions, which created basis in Günther’s stock.

Datamation Servs., Inc. v. Commissioner, T.C. Memo. 1976-252.

     B.   Guaranteed Bank Loan Assumed by Petitioner in 1994

     For FYE May 31, 1994, petitioner claimed the equivalent of a

bad debt deduction for the guaranteed bank debt assumed as part

of GAI’s acquisition of Günther.    Petitioner argues that, because

it was an accrual basis taxpayer entitled to a deduction when all


     25
      Our holding eliminates the need to discuss the remaining
requirements of sec. 166.
                                - 42 -

events that fix the liability have occurred and the amount of the

liability can be determined with reasonable accuracy, its

assumption of liability for Günther’s bank loans it had

guaranteed should give rise to an immediate deduction.     We

disagree.     A taxpayer’s assumption of liability for guaranteed

bank debt does not give rise to an immediate deduction, even when

the taxpayer utilizes the accrual method of accounting and even

when there is no right of subrogation or the right of subrogation

is worthless.26    Black Gold Energy Corp. v. Commissioner, 99 T.C.

482 (1992), affd. without published opinion 33 F.3d 62 (10th Cir.

1994).     Rather, the event giving rise to a deduction is the

taxpayer’s payment of the liability.     Id. at 488.

     The record in this case establishes only that Flint assumed

liability for Günther’s guaranteed bank loans during FYE May 31,

1994.     Petitioner introduced no evidence establishing how much,

if any, of the bank loans Flint actually paid during FYE May 31,

1994, after it assumed liability for them.     Consequently, we hold

that petitioner has failed to prove it is entitled to a bad debt

deduction equal to the amount of the guaranteed bank loans

assumed during FYE May 31, 1994.




     26
      The assumption of liability also does not create any basis
until the obligation is paid. Sec. 1.166-9(c), Income Tax Regs.
                               - 43 -

II.   Worthless Stock Deductions

      A.   Deduction Claimed on FYE May 31, 1992, Return

      We now consider whether petitioner’s shares of Günther’s

stock were worthless as of May 31, 1992.    Petitioner claimed a

worthless stock deduction for FYE May 31, 1992, in an amount

equal to its basis27 in its Günther shares as of May 31, 1992.

Petitioner asserts that it is entitled to the deduction under

section 165 because the shares became worthless during FYE May

31, 1992.    Respondent asserts that petitioner has failed to prove

its shares of Günther’s stock became worthless.




      27
      In both its opening and reply briefs, petitioner asserted
it was entitled to claim an increased worthless stock deduction
in the event we held that items constituting the intercompany
account balance were capital contributions. Respondent did not
dispute that such capital contributions increased petitioner’s
basis; respondent contended only that Günther was not worthless.
     Petitioner’s adjusted basis in its Günther stock as of May
31, 1992, was $7,374,438 before any adjustment attributable to
the bad debt issue. Our conclusion that amounts constituting the
intercompany account balance as of FYE May 31, 1992, 1993, and
1994 were contributions to Günther’s capital when made means that
petitioner’s adjusted basis in Günther’s stock as of May 31,
1992, must be increased by the intercompany account balance as of
that date. Petitioner’s adjusted basis in Günther’s stock as of
May 31, 1992, recomputed in accordance with this opinion, was
$13,938,562. Our analysis of whether Günther’s stock was
worthless must take into account the increased equity and
decreased liability resulting from our decision on the bad debt
issue. See Datamation Servs., Inc. v. Commissioner, T.C. Memo.
1976-252.
                            - 44 -

Section 165(g)28 authorizes a domestic corporation owning


28
     Sec. 165(g) provides in pertinent part:

        SEC. 165(g).   Worthless Securities.--

     (1) General rule.–-If any security which is a
capital asset becomes worthless during the taxable
year, the loss resulting therefrom shall, for purposes
of this subtitle, be treated as a loss from the sale or
exchange, on the last day of the taxable year, of a
capital asset.

     (2) Security defined.--For purposes of this
subsection, the term "security" means--

             (A) a share of stock in a corporation;

             (B) a right to subscribe for, or to
        receive, a share of stock in a corporation;
        or

             (C) a bond, debenture, note, or
        certificate, or other evidence of
        indebtedness, issued by a corporation * * *,
        with interest coupons or in registered form.

     (3) Securities in affiliated corporation.--For
purposes of paragraph (1), any security in a
corporation affiliated with a taxpayer which is a
domestic corporation shall not be treated as a capital
asset. * * * a corporation shall be treated as
affiliated with the taxpayer only if--

             (A) stock possessing at least 80 percent
        of the voting power of all classes of its
        stock and at least 80 percent of each class
        of its nonvoting stock is owned directly by
        the taxpayer, and

             (B) more than 90 percent of the
        aggregate of its gross receipts for all
        taxable years has been from sources other
        than royalties, rents (except rents derived
        from rental of properties to employees of the
        corporation in the ordinary course of its
        operating business), dividends, interest
                                                  (continued...)
                                 - 45 -

stock of an affiliated domestic or foreign corporation29 to claim

an ordinary loss with respect to the affiliated corporation’s

stock that becomes wholly worthless during the taxable year.

Sec. 165(g)(3); sec. 1.165-5(d)(1), Income Tax Regs.      A

corporation claiming a worthless stock loss under section

165(g)(3) must prove that the stock in question had value at some

point during the taxable year in which worthlessness is claimed

but ceased to have both "liquidating value" and "potential value"

by the end of that year.     Sec. 165(g)(1); Austin Co. v.

Commissioner, 71 T.C. 955, 970 (1979); Steadman v. Commissioner,

50 T.C. 369, 376 (1968), affd. 424 F.2d 1 (6th Cir. 1970); Morton

v. Commissioner, 38 B.T.A. 1270, 1278 (1938), affd. 112 F.2d 320

(7th Cir. 1940).     The standard we apply is whether a prudent

businessperson would have considered the stock of the affiliated

corporation to be worthless by the end of the taxable year for

which a worthless stock loss under section 165 is claimed.

Steadman v. Commissioner, supra.




     28
          (...continued)
              (except interest received on deferred
              purchase price of operating assets sold),
              annuities, and gains from sales or exchanges
              of stocks and securities.
     29
      For purposes of sec. 165, an affiliated corporation is one
in which the taxpayer owns directly stock possessing at least 80
percent of the voting power of all classes of such corporation’s
stock and at least 80 percent of each class of such corporation’s
nonvoting stock. Sec. 1.165-5(d)(2)(i)(a), Income Tax Regs.
                               - 46 -

          1.   Did Günther Have Value During FYE 1991?

     As shown in the consolidated report column of Günther’s

balance sheet as of May 31, 1991, Günther had a positive net

worth of $1,405,422.    Respondent does not dispute that Günther

had value during FYE May 31, 1992; it argues only that petitioner

has failed to prove Günther was worthless on May 31, 1992.

          2.   Did Günther Lack Liquidation Value As of May 31,
               1992?

     A corporation lacks liquidation value when its liabilities

exceed the value of its assets.    Steadman v. Commissioner, supra

at 376-377.    Following an investigation, petitioner concluded

that Günther’s liabilities substantially exceeded the aggregate

fair market value of Günther’s assets and that petitioner would

receive nothing upon Günther’s liquidation.30   In fact,

petitioner has demonstrated to our satisfaction that its

conclusion was accurate and that its management searched

diligently for any of Günther’s assets that had a fair market

value in excess of book value which could be liquidated to pay

down the guaranteed bank loans and mitigate petitioner’s losses

from its investment in Günther.




     30
      Günther’s consolidated balance sheet as of May 31, 1992,
shows a deficit in shareholder’s equity of $17,010,232. Our
conclusion that the intercompany advances were contributions to
capital and not debt requires an adjustment in that figure, but,
even after adjustment, Günther still had a substantial net
deficit as of May 31, 1992.
                              - 47 -

     Although respondent asserts that some value should be

attributed to goodwill, patents, and other intangibles not shown

on Günther's balance sheet, in our view the evidence showed that

Günther had destroyed its goodwill with ongoing quality problems

and that its patents had little or no value.   We find nothing in

the record to indicate that these assets had significant value,

and much to indicate that they did not.

     Respondent also argues that petitioner aggressively wrote

down the values of Günther’s assets to support its claims of

worthlessness and that use of discontinued operations treatment

was improper.   Respondent urges us to rely instead on Günther’s

German commercial report for its FYE April 30, 1992, which was

prepared on a going concern basis.

     Petitioner responds that the writedowns jeopardized its own

banking and surety relationships and thus threatened the

existence of the parent company.   Consequently, petitioner

contends that it had a strong disincentive to overstate any

writedowns.   Petitioner further contends that its treatment of

Günther as a discontinued operation was appropriate and that the

resulting adjustment in the value of Günther’s assets confirmed

management’s evaluation of the fair market value of those assets.

Petitioner also argues that it was required to use U.S. GAAP by

section 446(a) which states that a taxpayer shall compute taxable

income “under the method of accounting on the basis of which the

taxpayer regularly computes his income in keeping his books.”
                                - 48 -

     We find no support in the record for respondent’s

allegations of unduly pessimistic valuation in connection with

the discontinued operations writedowns.    Petitioner presented the

expert testimony of Justin A. Gannon, an audit partner in the San

Antonio office of Arthur Andersen LLP, on the propriety of

adopting discontinued operations treatment with respect to

Günther for FYE May 31, 1992.    Respondent stipulated that Mr.

Gannon was an expert in the field of accounting.    Mr. Gannon’s

report sets forth the underlying facts in support of his

conclusion that discontinued operations treatment was

appropriate.   Respondent did not offer any expert testimony to

rebut Mr. Gannon’s testimony.    Our consideration of all the

evidence in this case, including but not limited to Mr. Gannon’s

testimony, convinces us that petitioner’s decision to adopt

discontinued operations treatment was consistent with U.S. GAAP

and appropriate under the circumstances herein.31   Moreover,

petitioner has convinced us that its efforts with respect to

Günther were directed to minimizing the substantial economic

losses it reasonably anticipated from Günther’s catastrophic

financial implosion and were not structured to distort its tax

position.



     31
      We note that the value of Günther’s interest in Actium was
increased as a result of discontinued operations treatment. This
writeup belies respondent's claim that discontinued operations
treatment was undertaken solely to buttress petitioner's claim
that Günther had become worthless.
                                 - 49 -

        Respondent’s reliance on Günther’s German commercial report

for its FYE April 30, 1992, is likewise unsupported.       Petitioner

has amply demonstrated that Günther’s FYE April 30, 1992,

commercial report used the book values of Günther’s assets

instead of fair market values and that it did not realistically

present Günther’s true financial condition or adequately state

the value of petitioner’s investment in Günther.

        We hold that, because Günther’s liabilities substantially

exceeded the fair market value of its assets as of May 31, 1992,

Günther lacked liquidation value as of May 31, 1992.

            3.   Did Günther Lack Potential Value as of
                 May 31, 1992?

        A corporation lacks potential value when there is no

reasonable expectation that assets will exceed liabilities in the

future.     Steadman v. Commissioner, 50 T.C. at 376.     Generally, a

lack of potential value is established by showing that an

identifiable event, such as bankruptcy, liquidation, the

appointment of a receiver, or the cessation of normal business

operations, effectively has destroyed the corporation’s potential

value.     Id. at 376-377; Morton v. Commissioner, 38 B.T.A. at

1279.     Where, however, a corporation’s liabilities so greatly

exceed the value of the corporation’s assets and the

corporation’s assets and business are such that no reasonable

expectation of profit to the shareholders exists, the inability

of a taxpayer to point to an identifiable event as proof of a
                              - 50 -

lack of potential value is of no consequence.   Morton v.

Commissioner, supra at 1279; see also Steadman v. Commissioner,

supra at 377.

     The record in this case leads us overwhelmingly to the

conclusion that Günther had no potential value as of May 31,

1992.   After a thorough investigation prompted by the discovery

of the Omega transaction, petitioner understandably concluded

that Günther’s financial condition was so dire that petitioner

had no option but to minimize its losses and dispose of Günther

as soon as possible.   Petitioner considered several alternatives

in making its decision, ultimately opting for a course of action

that was designed to avoid Günther’s bankruptcy under German law

and any default by Günther on its bank loans.   Petitioner

concluded that a bankruptcy proceeding and/or a default on

Günther’s bank loans could result in the assertion of a variety

of contingent and potential liabilities and generate an even

greater financial loss attributable to its investment in Günther

than that projected from Günther’s orderly disposal.

     Both of petitioner’s experts opined that Günther was

finished as a going concern and that its stock was worthless as

of May 31, 1992.   Respondent offered no expert testimony to

refute their conclusions.   Moreover, although respondent argues

that certain assets were not listed in Günther’s FYE April 30,

1992, commercial report, he offered no evidence to rebut the

testimony of petitioner’s witnesses that the assets in question
                              - 51 -

had no value.   Given the overwhelming evidence of financial

catastrophe introduced by petitioner, respondent would have been

wise to offer some affirmative evidence to demonstrate Günther’s

potential value.   Respondent failed to do so.   The record

presented to us supports a conclusion that a prudent

businessperson would have considered Günther's stock to lack

potential value because the company's liabilities substantially

exceeded the fair market value of its assets, calculated on a

conservative basis, and Günther’s business was in such a state

that Günther’s assets could not reasonably be expected to exceed

its liabilities in the future.

     Our conclusion is consistent with that of the marketplace,

which confirmed that Günther's stock was worthless.    After hiring

consultants and spending months seeking a purchaser, petitioner

could not find a company willing to acquire Günther on acceptable

terms, even though it essentially was willing to give Günther

away.   Before the offer from GAI, the only offer that petitioner

received as a result of its efforts to dispose of Günther after

May 31, 1992, would have required petitioner to pay the acquiring

company the equivalent of over $12 million and to provide

guaranties and concessions worth millions.

     When petitioner finally convinced GAI to acquire Günther,

petitioner had to assume $3,709,460 in bank debt, release the

right to reinstate the intercompany account receivable of

$11,429,665 it previously had waived to shore up Günther’s German
                                - 52 -

commercial report, and forgive the remaining intercompany

receivable of $761,228.   Respondent argues, nevertheless, that

Günther’s stock had value because petitioner received a

promissory note of DM 5 million under which GAI promised to make

installment payments for Günther’s stock.      We do not think that

the receipt of a promissory note in April 1994 demonstrates that

Günther’s stock had value as of May 31, 1992.      The amount of the

bank loans petitioner assumed, combined with petitioner’s

additional advances to Günther during FYE 1993 and 1994,

substantially exceeded the face value of the promissory note.

The promissory note obligated GAI to pay petitioner DM 5,000,000

only after petitioner had reconfigured Günther’s balance sheet by

eliminating a substantial part of Günther’s fixed and contingent

liabilities as of the date of sale.      If anything, the terms of

the sale support our conclusion that Günther’s stock was

worthless as of May 31, 1992.    Günther’s continuing financial

problems effectively forced petitioner to provide economic

benefits worth millions to GAI to facilitate the sale.

     In a nutshell, respondent’s argument is that Günther was

merely undergoing a downturn and that, with sufficient

recapitalization, it would make a full recovery.      In support of

his argument, respondent notes that Günther has become marginally

profitable in the hands of GAI in the years following

petitioner’s sale of the company.    While this point appears to

weigh against our conclusion that Günther lacked potential value,
                               - 53 -

it must be remembered that GAI acquired a very different company;

on the date of its acquisition by GAI, Günther had been relieved

of all liability for its outstanding bank loans and petitioner’s

advances.    While GAI was willing to acquire Günther, with the

hope of restoring it to profitability, a loss is not any less

definite and ascertained because, in a later year, someone is

willing to take a chance on the losing venture at a nominal

price.    Steadman v. Commissioner, 50 T.C. at 378; Pearsall v.

Commissioner, 10 B.T.A. 467, 469 (1928).

     Respondent argues that this is not a case like those cited

by petitioner32 in which we found a lack of potential value

despite continued operation or the absence of bankruptcy or

liquidation proceedings because, in those cases, “the companies

were defunct as a result of various fundamental factors

precluding all prospect of future worth.”    According to

respondent, no fundamental factor precluded Günther’s prospects

of future worth; Günther was simply the victim of gross

mismanagement, and the financial consequences of that

mismanagement could be reversed, and were reversed, with time.

Respondent contends that the facts of this case are more

analogous to those in Wally Findlay Galleries Intl., Inc. v.




     32
      De Loss v. Commissioner, 28 F.2d 803 (2d Cir. 1928), affg.
6 B.T.A. 784 (1927); Preston v. Commissioner, 7 B.T.A. 414
(1927); Remington Typewriter Co. v. Commissioner, 4 B.T.A. 880
(1926); Emhart Corp. v. Commissioner, T.C. Memo. 1998-162.
                              - 54 -

Commissioner, T.C. Memo. 1996-293, and Datamation Servs., Inc. v.

Commissioner, T.C. Memo. 1976-252.     We disagree.

     In Wally Findlay Galleries Intl., Inc. v. Commissioner,

supra, we concluded that the taxpayer’s French subsidiary was

insolvent by only $26,228 and that the taxpayer had failed to

sustain its burden of proving that the subsidiary lacked

potential value.   In this case, Günther’s insolvency,

conservatively calculated, totaled several million dollars and

was coupled with severe operational problems exacerbated by inept

and perhaps dishonest management.    In Datamation Servs., Inc. v.

Commissioner, supra, we concluded that the Datamation subsidiary

was barely insolvent and needed only minor capital financing in

order to continue as a going concern.

     The severity of Günther’s financial problems was evident,

not just to petitioner but to third parties who considered

acquiring Günther after May 31, 1992.    Günther’s situation more

closely resembled the dire financial situations described in

cases cited by petitioner.   E.g., Ainsley Corp. v. Commissioner,

332 F.2d 555 (9th Cir. 1964), revg. T.C. Memo. 1963-183; De Loss

v. Commissioner, 28 F.2d 803 (2d Cir. 1928), affg. 6 B.T.A. 784

(1927); Steadman v. Commissioner, 50 T.C. 369 (1968); Preston v.

Commissioner, 7 B.T.A. 414 (1927); Emhart Corp. v. Commissioner,

T.C. Memo. 1998-162; Harrington v. Commissioner, T.C. Memo. 1972-

181; Richards v. Commissioner, T.C. Memo. 1959-64.
                               - 55 -

     In connection with his argument that Günther had potential

value as of May 31, 1992, respondent also raises a policy

argument, arguing petitioner’s position creates the possibility

for abuse under section 165(g)(3).      According to respondent, a

parent corporation that owns a subsidiary in need of

recapitalization could delay providing funding, declare the stock

worthless, and then recapitalize the company.      We reject

respondent’s argument because we do not see any abuse present in

this case.    Petitioner faced a very real financial crisis in

1992, which threatened to undermine its own financial stability.

It was not playing games designed to obtain an improper tax

advantage.

         4.    Conclusion

     Under the well-established standards applicable to a

worthless stock loss, it is clear that a taxpayer need not be an

“incorrigible optimist” with respect to his investment.        Steadman

v. Commissioner, supra at 378 (quoting United States v. White

Dental Manufacturing Co., 274 U.S. 398 (1927)).      We believe that

a prudent businessperson would have concluded that Günther lacked

both liquidation value and potential value in FYE May 31, 1992.

Petitioner has proven it incurred a worthless stock loss for FYE

1992 in an amount equal to the adjusted basis of its Günther

stock as of May 31, 1992.    We hold that petitioner may deduct

that loss on its consolidated tax return for FYE 1992, the year

the stock became worthless.    See sec. 165(g)(1).
                                - 56 -

       B.   Deduction Claimed on FYE May 31, 1993, Return

       Petitioner also claimed a worthless stock deduction in the

amount of $2,435,876 in FYE 1993.     This amount represents the

basis created by the first waiver subject to reinstatement less

the amount of the intercompany receivable that was deducted as a

bad debt in FYE May 31, 1992.

       In order to claim a worthless stock loss, the stock must

become worthless during the taxable year.     See sec. 165(g)(1).

Thus, a taxpayer claiming a worthless stock loss must prove that

the security had value anytime during the year, and that it

became completely worthless during the year the deduction is

claimed.     Steadman v. Commissioner, supra at 376.

       On brief, petitioner conceded that the worthless stock loss

it claimed on its FYE 1993 tax return is not deductible under

section 165 but argued instead that the amount is deductible

under section 166 as a bad debt.     We reject this argument.   As

discussed previously, the amounts in question were capital

contributions which cannot be deducted as bad debts under section

166.    Lidgerwood Manufacturing Co. v. Commissioner, 22 T.C. 1152

(1954), affd. 229 F.2d 241 (2d Cir. 1956); Plante v.

Commissioner, T.C. Memo. 1997-386, affd. 168 F.3d 1279 (11th Cir.

1999); W.A. Krueger Co. v. Commissioner, T.C. Memo. 1967-192.

Because the amounts in question do not qualify as bona fide debt

and because petitioner conceded on brief that it is not entitled

to deduct a worthless stock loss with respect to advances made on
                               - 57 -

Günther’s behalf after May 31, 1992, we sustain respondent's

determination regarding petitioner’s FYE May 31, 1993, worthless

stock deduction.

III.    Conclusion

       Because petitioner’s shares of Günther’s stock became

worthless during FYE May 31, 1992, petitioner is entitled to

deduct a worthless stock loss of $13,938,562 for that year but is

not entitled to any of the bad debt deductions claimed.

Consistent with respondent’s concession and this opinion,

additional amounts charged to the intercompany account after May

31, 1992, excluding only the bank debt assumed during FYE 1994,

shall be taken into account in computing petitioner’s capital

loss from the sale of Günther in FYE May 31, 1994.

       We have considered all arguments for a result contrary to

that expressed herein, and, to the extent not discussed above, we

conclude that those arguments are irrelevant, moot, or meritless.

       To reflect the foregoing,


                                          Decision will be entered

                                     under Rule 155.
