                  T.C. Memo. 1996-548



                UNITED STATES TAX COURT



      AMERICAN UNDERWRITERS, INC., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 14263-95.            Filed December 18, 1996.



     P and K are related corporations that bought and
sold securities for their own accounts. P and K
invested primarily in an innovative and risky type of
option, and P and K guaranteed each other's investment
in the options. P transferred money to K, or to
brokerage firms on K's behalf. P recorded these
transfers as "loans". On Oct. 19, 1987, stock prices
dropped 50 percent, and P and K suffered extraordinary
losses on that day. For its 1987 taxable year, P
deducted $5 million of the advances to K as a bad debt.
Held: The advances were debt. Held, further: The
$5 million debt became worthless in the year of the
deduction. Held, further: P is not liable for the
additions to tax determined by R.
                                - 2 -

     Alfred Roven (an officer) and Joy Martin (specially

recognized), for petitioner.

     Rebecca T. Hill and Bryce A. Kranzthor, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:    American Underwriters, Inc., petitioned the

Court to redetermine respondent's determination with respect to

its 1987 and 1988 taxable years.   For petitioner's taxable year

ended February 29, 1988, respondent determined a $1,012,554

deficiency and a $53,188 addition thereto under section

6653(a)(1)(A).   Respondent also determined that the

time-sensitive provision of section 6653(a)(1)(B) applied to the

entire deficiency.   For petitioner's taxable year ended

February 28, 1989 (petitioner's 1988 taxable year), respondent

determined a $261,672 deficiency and a $13,084 addition thereto

under section 6653(a)(1).

     Following concessions, we must decide:

     1.   Whether certain advances were debt.    We hold they were.

     2.   Whether any of these advances were worthless as of

February 29, 1988.   We hold they were to the extent described

herein.

     3.   Whether petitioner is liable for the additions to tax

determined by respondent.   We hold it is not.
                               - 3 -

     Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the subject years.    Rule

references are to the Tax Court Rules of Practice and Procedure.

                          FINDINGS OF FACT

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

The stipulated facts and exhibits submitted therewith are

incorporated herein by this reference.   Petitioner's principal

place of business was in San Anselmo, California, when it

petitioned the Court.

     Petitioner was organized by Alfred Roven (Mr. Roven) on

October 20, 1980, primarily to transact business in the

securities market, buying and selling securities, bonds, and

derivatives, among other things.   Mr. Roven is petitioner's sole

shareholder, as well as its president and one of its two

directors.   Joy Martin (Ms. Martin) is petitioner's other

director, and she is its secretary and bookkeeper.

     Mr. Roven organized Kenilworth Corp. (Kenilworth), on

January 12, 1982, to trade securities and to provide consulting

services on the trading of securities.   Mr. Roven owns 40 percent

of Kenilworth's stock, and its remaining stock is equally owned

by two of his children.   Kenilworth's taxable year ends on

May 31, and it began filing a consolidated income tax return with

a lone subsidiary effective with its taxable year ended May 31,
                                - 4 -

1988 (Kenilworth's 1987 taxable year).1   Kenilworth had $1,000 of

capital stock outstanding at the beginning and end of its 1987

taxable year.

     During all years relevant herein, petitioner and Kenilworth

invested primarily in Limited Price Options (LPO's) sold by Bear,

Stearns & Co., Inc. (Bear Stearns), and Prudential Bache & Co.

(Prudential Bache).   An LPO is an extremely high risk,

sophisticated financial instrument designed for aggressive hedge

funds, risk arbitageurs, and professional traders.   In general, a

purchaser of an LPO pays 20 percent of the market value of a

package of securities in return for the right to buy those

securities at a set price during a set period of time.    Once

purchased, an LPO may be traded only with the brokerage firm from

which it was purchased.    An LPO is like a conventional option in

that it creates leverage to enhance the purchaser's potential

gain in a strong market.   However, the premium paid for an LPO is

generally lower than the premium paid for a comparable

conventional option because the terms of the LPO provide that it

will automatically expire without value whenever the market value

of the related securities falls below a set dollar amount

(Expiration Price).   To minimize the risk of loss in a declining

market, a purchaser of an LPO may execute an addendum to an LPO

     1
       Kenilworth acquired more than 50 percent of the stock of
this subsidiary during Kenilworth's 1987 taxable year. Unless
otherwise indicated, our references to Kenilworth are without
regard to its subsidiary.
                               - 5 -

contract, under which the seller/brokerage firm will repurchase

the LPO and issue a new one (for an additional cost) whenever the

value of the related securities equals the Expiration Price.

     Bear Stearns acquired the underlying securities for the

LPO's that it sold to petitioner or Kenilworth.    When Bear

Stearns sold an LPO to petitioner or Kenilworth, Bear Stearns

charged the purchaser a purchase commission that was based on the

gross cost of the underlying securities.   When the purchaser

exercised or otherwise disposed of the LPO, Bear Stearns charged

the purchaser a selling commission based on the gross proceeds of

the securities.   Prudential Bache followed a similar, overall

procedure with respect to the LPO's that it sold to petitioner or

Kenilworth.

     Pursuant to the terms of the LPO's purchased by petitioner

or Kenilworth, the Expiration Price was set at an amount that

reflected a 3 percent decline in the value of the related

securities.   Under the terms of the addendums that petitioner or

Kenilworth entered into with the seller/brokerage firm, the

seller would:   (1) Repurchase an LPO every time that the market

value of the related securities equaled the Expiration Price and

(2) simultaneously issue a new LPO for the same securities, the

payment of which was due on the day of issuance.    The repurchase

price of an LPO equaled the amount by which the proceeds received

from selling the underlying securities (usually the market price

less commissions and other costs) exceeded the exercise price for
                               - 6 -

that day.   If the purchaser failed to transfer the requisite

funds to the seller within the required period of time, the LPO

would cancel and the seller would retain all of the funds that

the purchaser had previously paid to purchase it.

     Mr. Roven directed the trading activities of petitioner,

Kenilworth, and certain other related entities that are not

directly relevant to our decision herein.   Mr. Roven caused

petitioner (or, sometimes, one of the other related entities) to

buy the positions in his recommended securities (including

LPO's), and he divided the interests in these positions among the

entities in a preset manner.   All purchases of LPO's with the

funds of petitioner were contemporaneously recorded as "loans" to

Kenilworth and the other related entities to the extent that each

entity (including Kenilworth) benefited therefrom.   None of these

"loans" (hereinafter referred to as advances) were evidenced by a

written agreement (e.g., a note) because Mr. Roven did not

believe that he needed to prepare one, given the fact that he

controlled all of the entities and they were commonly owned.     For

the same reason, none of the advances were directly secured, and

none of the entities paid interest on any of the advances.

     Petitioner and Kenilworth considered the advances to be debt

that was payable on demand without a set maturity date, and they

intended at the time of each advance that it would be repaid

shortly after it was made.   Prior to October 19, 1987, Kenilworth

regularly repaid each advance shortly after it received the
                                - 7 -

advance.   On October 19, 1987, the Dow Jones industrial average

fell 22.6 percent (hereinafter, this fall is referred to as the

Crash), which was the worst decline since World War I and greater

from a numerical standpoint than the 12.82 percent drop on

October 28, 1929.   Some stocks dropped 50 percent on that day,

and petitioner and Kenilworth's 3 percent trigger for repurchase

of the LPO's was hit 15 times, resulting in extraordinary losses

to them.   Kenilworth lost at least $23.6 million on the day of

the Crash, mainly with respect to its LPO's.

     Before the Crash, petitioner and Kenilworth had entered into

cross-collateral and guarantee agreements with Bear Stearns and

Prudential Bache under which:   (1) Every LPO owned by petitioner

was collateralized by an LPO owned by Kenilworth, and vice versa,

and (2) petitioner was liable for any charges incurred by

Kenilworth on its purchase of an LPO, and vice versa.    Mr. Roven

approved all of these agreements.   Petitioner and Kenilworth were

both financially healthy and profitable when they signed these

agreements, and they entered into these agreements with a proper

and valid business purpose, both providing consideration for the

agreements and receiving value therefrom.   Petitioner's primary

business purpose was to increase its profits and net worth, and

petitioner realized this purpose until the Crash.    The Crash

caused the leverage which had allowed petitioner and Kenilworth

to grow extraordinarily during 1986 and 1987 to backfire and

generate extraordinary losses to the two entities.
                              - 8 -

     In addition to the advances mentioned above, petitioner

transferred money to Kenilworth or to other parties (e.g., Bear

Stearns and Prudential Bache) on Kenilworth's behalf.    Petitioner

treated these transfers similarly to the advances above.    These

transfers were contemporaneously recorded in petitioner's books

as "loans", and petitioner intended at the time of each transfer

that the transfers would be repaid by Kenilworth.    Both

petitioner and Kenilworth treated these transfers as demand

loans, and Kenilworth regularly repaid all of these transfers

within 90 days of the transfer.   Prior to the Crash, petitioner

received timely repayment of all of its debts that were due from

Kenilworth. (Hereinafter, we collectively refer to the transfers

and advances as advances.)

     Kenilworth owed petitioner over $18 million in advances as

of the last day of Kenilworth's 1987 taxable year.    Petitioner

had advanced Kenilworth approximately $15 million of this sum to

support the cross-collateral and guarantee agreements.

Petitioner's board of directors (Board), following its evaluation

of the receivable from Kenilworth in consultation with advisers

(including petitioner's independent accountant (C.P.A.), a

certified public accountant who was extremely familiar with the

business and operation of petitioner, of Kenilworth, and of the

other related entities), unanimously agreed at a duly held board
                                - 9 -

meeting to forgive $5 million of the advances to Kenilworth.2

The C.P.A. had discussed with the Board whether all of the

advances to Kenilworth were worthless, and he had queried whether

petitioner could forgive the entire amount as a bad debt.    The

Board concluded conservatively that the uncollectible advances

totaled $5 million.    The Board believed that Kenilworth could not

repay this amount because it had a negative net worth as of

February 28, 1988, and Bear Stearns had canceled most (if not

all) of Kenilworth's LPO's on October 19, 1987.    The Board also

considered the composition of Kenilworth's assets, as well as

certain claims that it could make in regard to its trading

activities and the likelihood of success with respect thereto.




     2
         Petitioner's minutes for this meeting state as follows:

          During the fiscal year ended February 28, 1988
     through the normal course of its business activities,
     American Underwriters, Inc. has loaned the sum of
     $18,096,100.00 (Eighteen Million Ninety Six Thousand
     and One Hundred Dollars) to Kenilworth Corporation,
     Inc.

          As a result of the sharp downturn in the equities
     market during the month of October, 1987, Kenilworth
     Corporation, Inc. incurred extreme financial losses
     that strained its liquidity to the point of questioning
     its ability to continue its business operations as a
     viable going concern. In consideration of the above
     circumstances, American Underwriters, Inc. and
     Kenilworth Corporation Inc., formally agree to a
     partial relief of the debt obligation owed by
     Kenilworth Corporation, Inc. to American Underwriters,
     Inc. for the amount of $5,000,000.00 (Five Million
     Dollars).
                                - 10 -

     Before the Board forgave the $5 million amount, but after

the Crash, petitioner had made a formal demand upon Kenilworth to

repay all moneys that it owed petitioner (including the

advances).   Kenilworth was unable to honor this demand.    Before

the Crash, Kenilworth had honored all of its obligations to

petitioner, and petitioner had always transferred money to or for

the benefit of Kenilworth with the belief that it would repay

petitioner in full.

     Following the Crash, Kenilworth's primary asset was a piece

of real estate.     Petitioner continued to transfer money to

Kenilworth for its trading operation, and Kenilworth continued to

make timely payments on a debt that encumbered the real estate.

On September 12, 1988, Kenilworth sold the real estate for

$481,554, and it paid petitioner the largest portion of the sales

proceeds.    The amount paid did not reduce the amount considered

owed below $5 million.

     For its 1985 through 1988 taxable years, Kenilworth reported

pre-NOL and pre-special deduction taxable income (loss) on its

Federal income tax returns equal to ($1,323), $234,590,

($6,943,436), and ($4,038,323), respectively.     It reported the

following "gross receipts"     and "cost of goods sold":

     Taxable Year      Gross receipts      Cost of goods

         1985           $86,736,153         $86,068,552
         1986           249,750,510         247,641,780
         1987           193,311,229         201,493,250
         1988           200,329,220         202,253,502
                                 - 11 -

It reported the following unappropriated retained earnings at the

beginning and end of each taxable year:

                     Beginning              End
     Taxable Year     of year             of year

        1985        $168,435            $165,535
        1986         165,535             400,485
        1987         400,485            (971,002)
        1988        (971,002)         (6,858,975)

     Petitioner reported negative taxable income on each of its

1985 through 1988 Federal income tax returns.       Petitioner also

reported the following "gross receipts" and "cost of goods sold":

     Taxable Year    Gross receipts          Cost of goods

        1985         $307,524,610            $307,404,014
        1986          521,391,751             520,838,947
        1987          369,142,037             367,746,493
        1988          175,924,620             175,473,765

     On November 16, 1987, petitioner and the related entities

signed a settlement agreement with Bear Stearns, in which the

parties agreed to resolve all of their differences by

Kenilworth's paying Bear Stearns a $2.5 million debt owed to Bear

Stearns.   Pursuant to this settlement agreement, all of the other

claimants paid or received nothing.

     On April 29, 1988, Kenilworth filed a claim for arbitration

against Prudential Bache with the New York Stock Exchange, Inc.,

in which it alleged that Prudential Bache owed it over $3 million

as a result of transactions occurring in October 1987.

Petitioner and the other related entities later joined the claim

on the side of Kenilworth, and Prudential Bache filed a
                               - 12 -

counterclaim against petitioner and the other related entities

praying for the sum of $5,302,901.31.    On January 31, 1991, the

claim and counterclaim were denied in their entirety, and each

side bore its own costs and attorney's fees.

     Petitioner's 1987 and 1988 Federal income tax returns were

prepared by the C.P.A.   In connection therewith, Ms. Martin gave

the C.P.A. the books and records of petitioner, Kenilworth, and

the other related entities.3   Petitioner's 1987 return reported a

deduction for a $5 million bad debt.     Respondent disallowed this

deduction, stating in the notice of deficiency that "It has been

determined that a $5,000,000 bad debt loss claimed in the tax

year ended February 29, 1988, is not deductible because it does

not qualify under sections 162 or 165 of the Internal Revenue

Code."

                               OPINION

     The primary issue before the Court is whether petitioner may

deduct $5 million of the advances that it claims were loans to

Kenilworth, and that it claims were worthless at the end of its

1987 taxable year.   Respondent determined that petitioner could

not deduct any of this amount as either:    (1) An ordinary and

necessary business expense under section 162 or (2) a loss under

     3
       Ms. Martin reconciled each broker and bank statement at
the end of each business day, and she met with Mr. Roven daily to
assure the accuracy of her reconciliations and the other business
records. At these meetings, Ms. Martin and Mr. Roven also
discussed that day's transactions, and he directed her to make an
intercompany transfer of funds to the entities that needed cash.
                               - 13 -

section 165.    Respondent's counsel, during her opening statement

at trial, conceded that a loss occurred, but she disputed:

(1) The amount of the loss, (2) that the advances were loans, as

opposed to contributions to Kenilworth's capital, and (3) that

Kenilworth intended to repay the advances, to the extent they

were loans.    On brief, respondent primarily argues that the

advances were not loans because they bear none of the formal

indicia of debt.    According to respondent, petitioner and

Kenilworth classified the advances as loans when they prepared

their income tax returns because they wanted to transfer losses

between themselves.    If the advances were loans, respondent

alternatively argues, the loans were not worthless because

Kenilworth was solvent at the time of forgiveness.

1.   Debt or Contribution to Capital

      A taxpayer may deduct any debt that becomes wholly or

partially worthless during the taxable year.     Sec. 166(a).   The

term “debt” connotes a bona fide debtor-creditor relationship

that obligates the debtor to pay the creditor a fixed or

determinable sum of money.    Sec. 1.166-1(c), Income Tax Regs.

Capital contributions are not debt.     Capital contributions are

equity.   Roth Steel Tube Co. v. Commissioner, 800 F.2d 625, 629

(6th Cir. 1986), affg. T.C. Memo. 1985-58; Calumet Indus., Inc. &

Subs. v. Commissioner, 95 T.C. 257, 284 (1990).

      A taxpayer must establish the validity of a debt before any

portion of it may be deducted under section 166.     American
                               - 14 -

Offshore, Inc. v. Commissioner, 97 T.C. 579, 602 (1991).     Whether

a transfer creates a debt is a question of fact, for which the

taxpayer bears the burden of proof.     Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933); Bauer v. Commissioner,

748 F.2d 1365, 1368 (9th Cir. 1984), revg. T.C. Memo. 1983-120;

A. R. Lantz Co. v. United States, 424 F.2d 1330, 1334 (9th Cir.

1970); Crown v. Commissioner, 77 T.C. 582, 598 (1981); Gilbert v.

Commissioner, 74 T.C. 60, 64 (1980).     The key to this factual

determination turns primarily on the taxpayer's actual intent, as

shown by the circumstances and condition of the transfer.

Bauer v. Commissioner, supra at 1367-1368; A. R. Lantz Co. v.

Commissioner, supra at 1333.   In passing on this intent, the

Court of Appeals for the Ninth Circuit, to which appeal in this

case lies, has considered 11 factors.    These factors, which are

not equally significant and none of which is controlling by

itself, are:   (1) The names given to the certificates evidencing

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

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

payment of principal and interest, (5) participation in

management as a result of the advances, (6) a status of the

advances equal to or inferior to that of regular corporate

creditors, (7) the intent of the parties, (8) the identity of

interest between creditor and stockholder, (9) a thin or adequate

capitalization, (10) the ability of the corporation to obtain

loans from outside sources, and (11) the payment of interest only
                              - 15 -

out of dividend money.   Hardman v. United States, 827 F.2d 1409,

1411-1412 (9th Cir. 1987); Bauer v. Commissioner, supra at 1368;

A. R. Lantz Co. v. United States, supra at 1333.   These factors

help distinguish:   (1) Shareholders who transfer money to

corporations in exchange for equity interests that are repayable

based on the corporations' performance, from (2) creditors who

transfer money to corporations in return for obligations that are

payable regardless of the corporations' performance.   Bauer v.

Commissioner, supra at 1367; A. R. Lantz Co. v. United States,

supra at 1334.

     The above-mentioned factors focus primarily on ascertaining

the intent of the parties to the transfer through their objective

and subjective expressions.   Bauer v. Commissioner, supra at

1367; A. R. Lantz Co. v. United States, supra at 1333-1334;

Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973).

In passing on their intent, we ask ourselves:   (1) Did they truly

intend to create a debt, (2) was their intention consistent with

the economic reality of creating a debtor-creditor relationship,

(3) did the transferor reasonably expect to be repaid, and

(4) would an unrelated lender have advanced money to the

transferee in the same amount and on the same terms.   Litton Bus.

Sys., Inc. v. Commissioner, supra at 377.   We look to the

substance of the transfer, rather than its form.   Gregory v.

Helvering, 293 U.S. 465 (1935); Hardman v. United States, supra

at 1411.   We apply special scrutiny in cases such as this one,
                                - 16 -

where the transferor and transferee are related.    Hardman v.

United States, supra at 1412.    The mere fact that the transferor

and the transferee are related, however, does not necessarily

mean that any transfer between them lacks economic substance.

Id.

      Based on our careful review of the entire record, and after

evaluating each of the 11 factors mentioned above, we answer the

four questions set forth immediately above in the affirmative.

The record points to the conclusion that the advances were loans

from petitioner to Kenilworth.    Although the tangible

documentation for the advances is less than complete, we conclude

from the record that petitioner and Kenilworth intended to create

a debtor-creditor relationship, that their intent was consistent

with the economic reality of creating a debtor-creditor

relationship, that petitioner wanted Kenilworth to repay each

advance timely and expeditiously, that Kenilworth intended to

repay each advance in that manner, and that an unrelated lender

would have advanced funds to Kenilworth in a fashion similar to

that employed by petitioner.

      Before setting forth our analysis of the 11 factors,

we pause briefly to state our view of the relevant witnesses.

With respect to Mr. Roven and Ms. Martin, the two witnesses who

testified on behalf of petitioner, we find them to be credible in

their testimony that the advances were intercompany loans.

Whereas respondent would have us minimize their testimony and
                                - 17 -

sustain her determination mainly because some of the formalities

of debt were not present, we refuse to do so.       We find that

petitioner's claim to the deduction was strongly supported by

their testimony.4   See, e.g., Diaz v. Commissioner, 58 T.C. 560,

564 (1972).   We also find that this claim is adequately supported

by the 11 factors, our analysis of which is set forth below.

     i.   Name of certificate

     We look to the name of the certificate evidencing purported

debt to determine the “debt’s” true label.       The issuance of a

debt instrument such as a promissory note points toward debt.

The issuance of an equity instrument such as a stock certificate

points toward equity.   Hardman v. United States, supra at 1412.

The mere fact that a taxpayer does not issue a formal debt

instrument to evidence a transfer of money will not preclude

classifying that transfer as debt.       In such a case, the Court

must consider all relevant evidence to determine whether the lack

of a formal debt instrument is inconsistent with the taxpayer's

claim that the alleged debt is truly debt.       See Estate of Mixon

v. United States, 464 F.2d 394, 403-404 (5th Cir. 1972); see also

American Offshore, Inc. v. Commissioner, 97 T.C. 579, 602 (1991).

The Court must also take into account the realities of the

     4
       In addition to the testimony of Mr. Roven and Ms. Martin,
petitioner relies on the testimony of the C.P.A., who was called
by respondent. Although we have some reservations about the
contents of the C.P.A.'s work papers, which are included in the
record, we find most of his testimony to be credible and
persuasive.
                               - 18 -

business world.    Santa Anita Consol., Inc. v. Commissioner, 50

T.C. 536, 550 (1968).

     Kenilworth failed to issue a note to petitioner to evidence

the advances as debt.   Under the facts at hand, however, we do

not consider this failure dispositive.   Not only did Kenilworth

fail to issue petitioner a debt instrument for the advances,

Kenilworth did not issue petitioner an equity instrument.

Moreover, Mr. Roven was the financial officer of both of these

entities, and he testified that the lack of a note stemmed from

his belief that notes were not required to document the advances

as debt.    Petitioner and Kenilworth were commonly controlled, and

petitioner recorded the advances as "loans" at or about the time

of each advance.   In addition, Kenilworth had a history before

the Crash of repaying the advances timely and expeditiously.

Loans between related entities are sometimes agreed upon

informally, without the formality of a note.   See Levenson &

Klein, Inc. v. Commissioner, 67 T.C. 694, 713-714 (1977).    In the

instant setting, we believe that petitioner's recording of the

advances as "loans" supports its argument that the advances are

debt, and that Kenilworth's failure to issue petitioner a formal

instrument of debt is not inconsistent with petitioner's

argument.

     This factor favors classifying the advances as debt.
                                - 19 -

     ii.     Fixed maturity date

     The presence of a fixed maturity date points toward debt.

The absence of a fixed maturity date usually points toward

equity.    Such an absence tends to show that repayment is more

likely tied to the fortunes of a business.      Hardman v. United

States, 827 F.2d at 1413; American Offshore, Inc. v.

Commissioner, 97 T.C. at 602.      The fact that a fixed maturity

date is absent from a case, however, does not necessarily mean

that a purported debt is actually equity.     In such a case, the

Court must ascertain whether the lack of a fixed maturity date is

explainable or otherwise negated by other evidence in the record.

See Hardman v. United States, supra at 1413.

     Because petitioner did not issue notes to evidence the

advances as debt, we do not find a written maturity date for the

advances' repayment.    We find, however, that the advances were

repayable on demand.    It is also relevant that Kenilworth had a

prior history of borrowing money from petitioner for short

periods of time, and of repaying timely these debts.      Estate of

Mixon v. United States, supra at 404.      The same is true with

respect to the fact that petitioner demanded that Kenilworth

repay petitioner all debts (including the advances) due it after

the Crash.    Such a demand for repayment is evidence of a

debtor-creditor relationship.      Montgomery v. United States,

87 Ct. Cl. 218, 23 F. Supp. 130 (1938); see also Sattelmaier v.

Commissioner, T.C. Memo. 1991-597.
                                - 20 -

     This factor is neutral, and we give it no weight.

     iii.    Source of repayment

     Repayment that is dependent upon corporate earnings points

toward equity.     Repayment that is not dependent on earnings

points toward debt.     Hardman v. United States, supra at 1413;

Roth Steel Tube Co. v. Commissioner, 800 F.2d 625, 632 (6th Cir.

1986), affg. T.C. Memo. 1985-58; In re Lane, 742 F.2d 1311, 1314

(11th Cir. 1984); American Offshore, Inc. v. Commissioner, supra

at 602.     Purported debt is usually equity when its repayment is

directly dependent on the profits of the debtor's business.

Segel v. Commissioner, 89 T.C. 816, 830 (1987).

     Respondent would have us rely primarily on Kenilworth's

balance sheets, with particular emphasis on its retained

earnings, to conclude that Kenilworth had a minimal net worth on

the relevant dates.    We refuse to do so.   Kenilworth's balance

sheets are based on historic cost and do not report current

value.    We note, however, that Kenilworth had a balance sheet net

worth of $400,485 at the beginning of its 1987 taxable year, and

that its balance sheet net worth only fell to negative $971,002

at the end of that year, notwithstanding the fact that it lost at

least $23.6 million on the day of the Crash.     Contrary to

respondent's assertion, we do not believe this factor supports a

finding of equity.

     This factor is neutral, and we give it no weight.
                                 - 21 -

       iv.   Right to enforce payment of interest and principal

       A definite obligation to enforce the payment of principal

and interest is evidence of debt.      Hardman v. United States,

supra at 1413; American Offshore, Inc. v. Commissioner, supra at

603.    The absence of security for the repayment of purported debt

generally points toward equity.      Roth Steel Tube Co. v.

Commissioner, supra at 632; In re Lane, supra at 1317.

       We find that petitioner could enforce Kenilworth's repayment

of the advances.      Although we do not also find that petitioner

could enforce the payment of interest, we give this fact little

regard.      We believe that Mr. Roven's credible testimony

adequately explains the lack of an interest provision from which

petitioner could seek enforcement.

       We also are untroubled by the fact that petitioner did not

receive any type of security for the advances.      Mr. Roven

testified that he did not require security because Kenilworth and

petitioner were commonly owned.      Moreover, Kenilworth had a solid

history of repaying petitioner timely and expeditiously.        We do

not believe that the absence of security under the facts at hand

precludes a finding of debt on this factor.

       This factor is neutral, and we give it no weight.

       v.    Participation and management

       If a transferor's right to participate in the management of

the transferee corporation increases as a result of the transfer

of funds, then the transferor may be a shareholder of the
                                - 22 -

transferee rather than its creditor.     A transferor's ability to

participate in the transferee's management may increase through

greater voting rights or a greater ownership interest.

Hardman v. United States, supra at 1413; Estate of Mixon v.

United States, 464 F.2d at 406; Lundgren v. Commissioner, 376

F.2d 623, 626 (9th Cir. 1967), revg. T.C. Memo. 1965-314;

American Offshore, Inc. v. Commissioner, supra at 603.

     We find no evidence in the record to suggest that

petitioner's right to participate in Kenilworth's management

increased as a result of the advances.    We find it unlikely,

however, that such an increase could have occurred, given the

fact that petitioner had no ownership interest in Kenilworth and

that Mr. Roven controlled both entities.

     This factor favors classifying the advances as debt.

     vi.   Subordination

     Subordination of purported debt to the claims of other

creditors points towards equity.     Hardman v. United States,

supra at 1413; Roth Steel Tube Co. v. Commissioner, supra at

631-632; Stinnett's Pontiac Serv., Inc. v. Commissioner, 730 F.2d

634, 639 (11th Cir. 1984), affg. T.C. Memo. 1982-314.    The fact

that an obligation to repay is subordinate to claims of other

creditors, however, does not necessarily mean that the purported

debt is really equity.     This is especially true when the advance

is given a superior status to the claims of shareholders.

Estate of Mixon v. United States, supra at     406.
                               - 23 -

     The record contains no persuasive evidence on the order of

priority of petitioner's debts to Kenilworth vis-a-vis the

latter's other creditors.    We note, however, that petitioner did

receive the lion's share of the proceeds from Kenilworth's sale

of its real estate following the Crash, which suggests that

petitioner held a claim to repayment that was greater than

Kenilworth's other creditors and to that of its shareholders.

     This factor is neutral, and we give it no weight.

     vii.    Intent of the parties

     We analyze all 11 factors to decipher petitioner's and

Kenilworth's true intent concerning whether the advances are debt

or equity.    Hardman v. United States, 827 F.2d at 1413.     Although

their objective expression of intent is important, we do not

consider it to be the most important factor and do not give it

special weight.    A. R. Lantz Co. v. United States, 424 F.2d at

1333.    We view petitioner and Kenilworth's objective expression

of intent as merely one factor to consider in passing on whether

they actually intended that the advances be debt.     Id.

     Petitioner's witnesses testified unequivocally that the

advances were meant to be loans.     We found their testimony to be

credible and persuasive, and we do not believe that the lack of a

promissory note or other formal indicia of debt deprives their

testimony of probative value under the facts herein.5       Hardman v.

     5
         We also find no merit in respondent's allegation that
                                                     (continued...)
                                - 24 -

United States, supra at 1412; see also Church of Scientology v.

Commissioner, 823 F.2d 1310, 1319 (9th Cir. 1987), affg. 83 T.C.

381 (1984); Sun Properties v. United States, 220 F.2d 171, 174

(5th Cir. 1955).

     This factor favors classifying the advances as debt.

     viii.     Capitalization

     Thin or inadequate capitalization points toward equity.

Hardman v. United States, supra at 1414.    The same is true with

respect to advances which are made to a corporation with an

excessive debt to equity ratio.    Roth Steel Tube Co. v.

Commissioner, 800 F.2d at 632.    The ratio of debt to equity is

measured by comparing the corporation's total liabilities to its

stockholders' equity.    Stockholders' equity equals the

corporation's assets minus its liabilities.    Bauer v.

Commissioner, 748 F.2d at 1368.

     The record does not allow us to measure with any precision

the ratio of Kenilworth's debt versus its equity on each of the

relevant dates.    We also do not know with certainty the ratio of

debt versus equity that is commonplace in a business such as

Kenilworth's.    Ordinarily, we count any gap in the record against

the taxpayer; i.e., the party with the burden of proof.     See

Rule 142(a).    In the setting of this case, however, we do not

     5
      (...continued)
petitioner and Kenilworth classified the advances as loans when
they prepared their income tax returns because they wanted to
transfer losses between themselves.
                                - 25 -

believe that the small gap in the record as it pertains to this

factor counts against petitioner.      Petitioner frequently and

regularly advanced funds throughout the subject years to or on

behalf of Kenilworth, and petitioner has supplied the Court with

reams of documents relating to these advances.      We could sift

through these documents and arrive at fair estimations of the

debt to equity ratio on many of the relevant dates.      We refuse to

do so, however, because we do not believe that these estimations

would be meaningful enough to cause this factor to lean in one

direction or the other.

       This factor is neutral, and we give it no weight.

       ix.   Identity of interest

       Advances made by stockholders in proportion to their

respective stock ownership point towards equity.      A sharply

disproportionate ratio between a stockholder’s ownership

percentage and the corporation's debt to that stockholder

generally points toward debt.       Roth Steel Tube Co. v.

Commissioner, supra at 630; Estate of Mixon v. United States,

supra at 409; American Offshore, Inc. v. Commissioner, supra at

604.

       Petitioner did not have a direct stock interest in

Kenilworth.     Thus, the advances from petitioner to Kenilworth

bore no relationship to a stockholding that petitioner had in

Kenilworth.     Respondent argues that the advances were actually

contributions to Kenilworth's capital that were considered made
                               - 26 -

by its shareholders (i.e., Mr. Roven and his children).

According to respondent, the fact that Kenilworth and petitioner

were related leads to a presumption that the advances were

constructive dividends to Mr. Roven (from petitioner), followed

by his constructive contribution to the capital of Kenilworth,

which is in part a gift to his children.    We are not persuaded by

respondent's argument, and the facts of this case do not support

it.

      This factor favors classifying the advances as debt.

      x.   Payment of interest out of "dividend money"

      The presence of a fixed rate of interest and actual interest

payments points toward debt.    The absence of interest payments in

accordance with the terms of a debt instrument points toward

equity.    American Offshore, Inc. v. Commissioner, 97 T.C. 579,

604 (1991).

      The advances were repayable without interest.      In the normal

setting, this fact would indicate that the advances were equity.

Mr. Roven testified, however, that he did not believe that he had

to pay interest on the advances for them to be debt.      We believe

that Mr. Roven's credible testimony adequately explains the lack

of interest payments in the setting of this case.     Given the

additional fact that petitioner and Kenilworth intended for all

of the advances to be short-term loans, we do not believe that

the lack of interest payments supports a finding of equity in

this case.
                                - 27 -

     This factor is neutral, and we give it no weight.

     xi.     Inability to obtain financing

     The question of whether a purported debtor could have

obtained comparable financing is relevant in measuring the

economic reality of a transfer.     Estate of Mixon v. United

States, 464 F.2d at 410.    Evidence that the purported debtor

could have obtained loans from outside sources points toward

debt.   Evidence that the taxpayer could not obtain loans from

independent sources points toward equity.       Calumet Indus., Inc. &

Subs. v. Commissioner, 95 T.C. at 287.       We look to whether the

terms of the purported debt were a "patent distortion of what

would normally have been available" to the debtor in an arms-

length transaction.    See Litton Bus. Sys., Inc. v. Commissioner,

61 T.C. at 379.

     The record contains no persuasive evidence on whether

Kenilworth could have obtained financing from an unrelated party

at the relevant times.     Kenilworth's history of making repayments

to petitioner, however, is a fact that we believe any reasonable

creditor would look favorably upon in deciding whether to loan

money to Kenilworth.    The same is true with respect to

Kenilworth's increased earnings from its 1985 taxable year to its

1986 taxable year.    See Bauer v. Commissioner, supra at

1369-1370.

     This factor favors classifying the advances as debt.
                                - 28 -

     xii.    Conclusion

     Many of the factors favor classifying the advances as debt,

and none of the factors supports a classification as equity.       We

conclude that the advances are debt.

2.   Worthlessness

     Respondent disallowed petitioner's deduction for a $5

million bad debt, stating in the notice of deficiency that

petitioner had not established that the deduction qualified under

section 162 or section 165.    Respondent argues in her brief that

the Court should sustain her disallowance because petitioner has

not proven that:     (1) Kenilworth became insolvent during the year

of the deduction or (2) petitioner was without a reasonable

prospect of recovery during that year.    Petitioner argues that it

should be allowed the $5 million deduction primarily because it

guaranteed the debt of Kenilworth, and it (petitioner) was forced

to transfer these funds to the brokerage firms to satisfy this

guarantee.

     Taxpayers may currently deduct the amount of any debt that

becomes worthless during a given year.    See sec. 166.   A loss

sustained by a guarantor unable to recover from the debtor is a

loss from a bad debt.     Putnam v. Commissioner, 352 U.S. 82

(1956); Black Gold Energy Corp. v. Commissioner, 99 T.C. 482, 486

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

1994); Martin v. Commissioner, 52 T.C. 140, 144 (1969), affd.

424 F.2d 1368 (9th Cir. 1970); see also Foretravel, Inc. v.
                                - 29 -

Commissioner, T.C. Memo. 1995-494.       As the Court explained in

Putnam:

     The reality of the situation is that the debt is an
     asset of full value in the creditor's hands because
     backed by the guaranty. The debtor is usually not able
     to reimburse the guarantor and in such cases that value
     is lost at the instant that the guarantor pays the
     creditor. But that this instant is also the instant
     when the guarantor acquires the debt cannot obscure the
     fact that the debt "becomes" worthless in his hands.
     [Putman v. Commissioner, supra at 89.]

     Whether a debt is worthless is a factual determination, on

which the taxpayer bears the burden of proof.       Estate of Mann v.

United States, 731 F.2d 267, 275 (5th Cir. 1984); Crown v.

Commissioner, 77 T.C. at 598.    This ordinarily entails proof of

identifiable events that establish that the debt will not be paid

in the future.   Estate of Mann v. United States, supra at 276.         A

taxpayer's subjective opinion that a debt is uncollectible,

standing alone, is not sufficient evidence that the debt is

worthless.   Fox v. Commissioner, 50 T.C. 813, 822      (1968), affd.

per curiam by an unreported order (9th Cir. 1970). Rather,

taxpayers must arrive at a conclusion of worthlessness through

the exercise of sound business judgment, basing their judgment

upon as complete information as is reasonably obtainable.       Andrew

v. Commissioner, 54 T.C. 239, 248 (1970).       Although evidence

demonstrating that the debtor is insolvent points to a conclusion

that a debt is worthless, see Gorman Lumber Sales Co. v.

Commissioner, 12 T.C. 1184, 1192 (1949), insolvency does not

establish conclusively that a debt is worthless, Cimarron Trust
                                - 30 -

Estate v. Commissioner, 59 T.C. 195, 200 (1972).     Consideration

must be given to the debtor's potential for improving its

financial position.     Dustin v.   Commissioner, 53 T.C. 491, 502

(1969), affd. 467 F.2d 47 (9th Cir. 1972).

     Based on our review of the record, we hold that at least

$5 million of the advances was worthless as of the close of

petitioner's 1987 taxable year.     See American Processing & Sales

Co. v. United States, 178 Ct. Cl. 353, 371 F.2d 842 (1967); see

also Baldwin v. Commissioner, T.C. Memo. 1993-433; Moffat v.

Commissioner, T.C. Memo. 1965-183, affd. 373 F.2d 844 (3d Cir.

1967).   The record leads us to conclude that Kenilworth was

insolvent at the end of petitioner's 1987 taxable year, and that

the cause of Kenilworth's insolvency was the Crash, which was

sudden and unexpected.    It was reasonable for the Board (on

behalf of petitioner) to conclude that Kenilworth was unable to

pay any of this $5 million in the future.     The Board arrived at

its conclusion of worthlessness through the exercise of sound

business judgment.    The Board considered all of the pertinent

information that was reasonably obtainable at the time, including

Kenilworth's potential for improving its financial position, and

it consulted petitioner's advisers including petitioner's

independent certified public account.

     We hold for petitioner on this issue.

3.   Additions to Tax
                              - 31 -

     Respondent also determined additions to tax for negligence

under section 6653(a)(1)(A) and (B) (for 1987) and section

6653(a)(1) (for 1988), asserting that petitioner's underpayment

of income taxes in each year was due to negligence or intentional

disregard of rules or regulations.     For the respective years,

section 6653(a)(1)(A) and section 6653(a)(1) impose an addition

to tax equal to 5 percent of the underpayment if any part of the

underpayment is due to negligence.     For petitioner's 1987 taxable

year, section 6653(a)(1)(B) imposes an addition to tax equal to

50 percent of the interest payable on the amount of the

underpayment that is due to negligence.     With respect to all of

these additions to tax, negligence includes a lack of due care or

a failure to do what a reasonable and ordinary prudent person

would do under the circumstances.    Neely v. Commissioner, 85 T.C.

934, 947 (1985).   Petitioner bears the burden of proving that

respondent's determination of negligence is erroneous.     Rule

142(a); Bixby v. Commissioner, 58 T.C. 757, 791-792 (1972).

     Following our review of the record, and in light of the

persuasive testimony of Mr. Roven and Ms. Martin, we hold that

petitioner is not liable for any of the additions to tax

determined by respondent.6   We believe that petitioner (through

its management) acted as a reasonable and prudent person would


     6
       This holding applies to the additions to tax as they
relate to both the determinations at issue and the determinations
that were conceded by petitioner.
                              - 32 -

have acted under the circumstances herein.   It is also relevant

that petitioner's 1987 and 1988 tax returns were prepared by the

C.P.A., who was knowledgeable about the business and operation of

all of the entities herein.



     In reaching all of our holdings herein, we have considered

each argument made by respondent for contrary holdings, and, to

the extent not mentioned above, find them to be irrelevant or

without merit.

     To reflect the foregoing,

                                        Decision will be entered

                                   under Rule 155.
