                       113 T.C. No. 29



                UNITED STATES TAX COURT



   LARRY W. AND CYNTHIA J. VAN WYK, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 15467-97.                     Filed December 21, 1999.



     P and L each own 50 percent of the stock in W, an
S corporation engaged in the business of farming. P
and his wife borrowed funds from L and his wife. On
the same day, P transferred to W funds equal in amount
to the loan from L and his wife. Part of the funds P
transferred to W paid off preexisting debts P owed to
W, and the remainder represents a new debt from W to P
(the loan). R determined that P is not at risk with
respect to the loan to W and disallowed P’s share of
W’s losses.
     1. Held: Pursuant to sec. 465(a), I.R.C., P is
not at risk with respect to the loan. The at-risk
treatment of amounts borrowed by a taxpayer and
contributed to an activity is governed by sec.
465(b)(1)(B), I.R.C. P is not considered to be at risk
with respect to the loan because sec. 465(b)(3)(A),
I.R.C., bars at-risk treatment with respect to amounts
that are borrowed from a person with a prohibited
interest in the activity, and L’s equity interest is
                                - 2 -


     such an interest. Sec. 465(b)(3)(B)(ii), I.R.C.,
     dealing with amounts borrowed by a corporation from its
     shareholders, does not apply to except P from sec.
     465(b)(3)(A), I.R.C.
          2. Held, further, P is not liable for penalties
     under sec. 6662, I.R.C.



     Burns Mossman, Steven J. Roy, and Angela L. Watson, for

petitioners.

     Deanna R. Kibler and Albert B. Kerkhove, for respondent.



                               OPINION


     WELLS, Judge:    Respondent determined deficiencies in

petitioners' income taxes of $60,371, $14,884, $6,875, and

$20,173 for their 1988, 1991, 1992, and 1993 taxable years

respectively, and additions to tax pursuant to section 66621 of

$2,977, $1,375, and $4,035 for their 1991, 1992, and 1993 taxable

years respectively.

     In the instant case, after concessions, we must decide the

following issues:    (1) Whether petitioner Larry Van Wyk is at

risk with respect to a loan he made to an S corporation in which

he owns 50 percent of the stock, where the source of the funds

constituting the loan is the other 50-percent shareholder and


1
     Unless otherwise noted, all section and Code references are
to the Internal Revenue Code in effect for the years in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
                               - 3 -

that shareholder's wife; and (2) whether petitioners are liable

for substantial understatement penalties under section 6662.

Background

     The parties submitted the instant case fully stipulated

pursuant to Rule 122.   The facts stipulated by the parties are

incorporated herein by reference and are found as facts in the

instant case.   When they filed their petition, petitioners

resided in Monroe, Iowa.

     During the years in issue, petitioner Larry Van Wyk

(petitioner) and his brother-in-law, Keith Roorda, each owned 50

percent of the stock of West View of Monroe, Iowa, Inc. (West

View), an S corporation engaged in the business of farming.

     On December 24, 1991, petitioners borrowed $700,000 from

Keith Roorda and his wife, Linda Roorda.     To evidence their debt

to Keith and Linda Roorda (the Roordas), petitioners executed a

promissory note bearing interest at 10.5 percent per annum.       The

note was unsecured.   Also, on December 24, 1991, petitioners

transferred $700,000 to West View.     Of that amount, $253,583

retired debts petitioners owed to West View with the remaining

$444,417 constituting indebtedness owed by West View to

petitioners (the loan).

     On their tax returns for 1988 through 1993, petitioners

reported one-half of the profits and losses from West View.

Respondent determined that petitioners' income should be
                               - 4 -

increased in the amounts of $252,503, $438,811, $115,230, and

$165,277 for the taxable years 1988, 1991, 1992, and 1993,

respectively, on account of the disallowance of petitioners'

deductions of West View's losses for those years.    Additionally,

respondent determined that, for 1993, petitioners' income should

be increased by $93,239, on account of the disallowance of

petitioners' deduction of West View's loss for the 1991 taxable

year, which petitioners carried forward to 1993.    Finally,

respondent determined that petitioners are liable for a

substantial understatement penalty pursuant to section 6662 for

taxable years 1991, 1992, and 1993.

Discussion

     We have been asked to resolve whether petitioner is at risk

with respect to the loan.2   Petitioners argue that petitioner

should be considered at risk with respect to the loan pursuant to

section 465(b)(1)(A).   Additionally, petitioners argue that

petitioner should be considered to be at risk with respect to

the loan pursuant to section 465(b)(1)(B).   Specifically,




2
     The parties have stipulated the losses which petitioners
will be entitled to deduct in accordance with our decision as to
whether petitioner is at risk with respect the loan.
Accordingly, other than the penalty issue discussed below, this
is the only issue which we are called upon to decide. The
parties also agree that the at-risk determination is to be made
at the shareholder level and not at the S corporation level.
                                - 5 -

petitioners maintain that section 465(b)(3)(B)(ii) applies to the

instant case.

     The relevant portions of section 465 provide as follows:

     SEC. 465. DEDUCTIONS LIMITED TO AMOUNT AT RISK.

          (a) Limitation to Amount at Risk.--

                 (1) In general.--In the case of-–

                      (A) an individual, and

                      (B) a C corporation with respect to which the
                 stock ownership requirement of paragraph (2) of
                 section 542(a) is met,

          engaged in an activity to which this section applies,
          any loss from such activity for the taxable year shall
          be allowed only to the extent of the aggregate amount
          with respect to which the taxpayer is at risk (within
          the meaning of subsection (b)) for such activity at the
          close of the taxable year.

                *     *     *     *     *      *     *

          (b) Amounts Considered at Risk.--

               (1) In general.--For purposes of this section, a
          taxpayer shall be considered at risk for an activity
          with respect to amounts including-–

                      (A) the amount of money and the adjusted
                 basis of other property contributed by the
                 taxpayer to the activity, and

                      (B) amounts borrowed with respect to such
                 activity (as determined under paragraph (2)).

               (2) Borrowed amounts.--For purposes of this
          section, a taxpayer shall be considered at risk with
          respect to amounts borrowed for use in an activity to
          the extent that he-–

                      (A) is personally liable for the repayment of
                 such amounts, or
                                 - 6 -

                    (B) has pledged property, other than property
               used in such activity, as security for such
               borrowed amount (to the extent of the net fair
               market value of the taxpayer's interest in such
               property).

              *        *    *     *        *   *    *

               (3) Certain borrowed amounts excluded.--

                    (A) In general.--Except to the extent
               provided in regulations, for purposes of paragraph
               (1)(B), amounts borrowed shall not be considered
               to be at risk with respect to an activity if such
               amounts are borrowed from any person who has an
               interest in such activity or from a related person
               to a person (other than the taxpayer) having such
               an interest.

                       (B) Exceptions.--

                            (i) Interest as creditor.--Subparagraph
                       (A) shall not apply to an interest as a
                       creditor in the activity.

                            (ii) Interest as shareholder with
                       respect to amounts borrowed by corporation.--
                       In the case of amounts borrowed by a
                       corporation from a shareholder, subparagraph
                       (A) shall not apply to an interest as a
                       shareholder.

              *        *    *     *        *   *    *

          (c) Activities to Which Section Applies.--

               (1) Types of activities.--This section applies to
          any taxpayer engaged in the activity of-- * * *

                       (B) farming (as defined in section 464(e)),
               * * *

Section 465(b)(1)(A)

     Petitioners' first argument is that petitioner should be

considered at risk with respect to the loan pursuant to section
                                 - 7 -

465(b)(1)(A).   Petitioners contend that section 1.465-10(d),

Example, Proposed Income Tax Regs., 44 Fed. Reg. 32240 (June 5,

1979) "clearly illustrates this principle."     The example provides

as follows:

     A is the single shareholder in X, an electing small
     business corporation engaged in an activity described
     in § 465(c)(1). A contributed $50,000 to X in exchange
     for its stock under § 351. In addition, A borrowed
     $40,000 for which A assumed personal liability. A then
     loaned the entire amount to X for use in the activity.
     * * * At the close of the taxable year (without
     reduction for any loss of X) A's amount at risk is
     $90,000 ($50,000 plus $40,000). * * *

As we read the foregoing example, it does not contemplate a

situation where the amounts A contributed to X are borrowed by A

from a person who has an interest in X.    The source of the

contributed amounts is critical because it is section

465(b)(1)(B) and its related provisions, discussed below, rather

than section 465(b)(1)(A), that govern at-risk treatment for

amounts that are borrowed with respect to the activity.

     Petitioners additionally argue that section 1.465-10(c),

Proposed Income Tax Regs., 44 Fed. Reg. 32240 (June 5, 1979),

supports their argument that petitioner should be considered at

risk with respect to the loan.    The proposed regulation provides

that "The amount at risk of a shareholder of an electing small

business corporation * * * shall be adjusted to reflect any

increase or decrease in the adjusted basis of any indebtedness of

the corporation to the shareholder".     Id.   Petitioners' reliance
                               - 8 -

on section 1.465-10(c), Proposed Income Tax Regs., supra, is

flawed for the same reason we reject petitioners' argument

concerning section 1.465-10(d), Example, Proposed Income Tax

Regs., supra, i.e., the proposed regulation just does not

contemplate the source of the funds, an issue governed by section

465(b)(1)(B) and its related provisions.

     As to what is meant by "money * * * contributed by the

taxpayer to the activity" within the meaning of section

465(b)(1)(A), the proposed regulations provide:   "A taxpayer's

amount at risk in an activity shall be increased by the amount of

personal funds the taxpayer contributes to the activity."    Sec.

1.465-22(a), Proposed Income Tax Regs., 44 Fed. Reg. 32241 (June

5, 1979).   According to the proposed regulations, "personal

funds" of a taxpayer are those owned by the taxpayer and are not

those acquired through borrowing.   Sec. 1.465-9(f), Proposed

Income Tax Regs., 44 Fed. Reg. 32240 (June 5, 1979).

     Petitioners acknowledge the proposed regulations regarding

personal funds but note that they are over 19 years old and still

in proposed form.   Petitioners also note that the personal funds

requirement is not mentioned in either the statute or the

legislative history.   Accordingly, petitioners claim that the

proposed regulations carry little weight as to the personal funds

requirement.   We think it anomalous that petitioners embrace the

proposed regulations as support for their argument, yet argue
                                 - 9 -

that the proposed regulations do not apply when they present

contrary authority.   Nonetheless, proposed regulations are given

no greater weight than a position advanced by the Commissioner on

brief.   See, e.g., F.W. Woolworth Co. v. Commissioner, 54 T.C.

1233, 1265-1266 (1970).   Yet proposed regulations can be useful

as guidelines where they closely follow the legislative history

of the act.   See Estate of Wallace v. Commissioner, 95 T.C. 525,

547 (1990), affd. 965 F.2d 1038 (11th Cir. 1992).   We have

previously cited the section 465 proposed regulations for that

purpose.   See Melvin v. Commissioner, 88 T.C. 63 (1987), affd.

894 F.2d 1072 (9th Cir. 1990).

     To read section 465(b)(1)(A) as petitioners suggest would be

inconsistent with section 465(b)(1)(B).   Accordingly, we conclude

that Congress did not intend such a result and that such a

construction of the statute would be inappropriate.   See, e.g.,

Weinberger v. Hynson, Westcott & Dunning, Inc., 412 U.S. 609,

633-634 (1973) (interpreting a statute in such a manner "offends

the well-settled rule of statutory construction that all parts of

a statute, if at all possible, are to be given effect"); In re

Windsor on the River Associates, 7 F.3d 127, 130 (8th Cir. 1993);

Bokum v. Commissioner, 94 T.C. 126, 154 (1990), affd. 992 F.2d

1132 (11th Cir. 1993).

     Respondent also points to statements by the Staff of the

Joint Committee on Taxation as an explanation of how Congress
                              - 10 -

intended section 465(b)(1) to operate when there is an overlap in

coverage between section 465(b)(1)(A) and (B):

     The amounts borrowed by the taxpayer and then
     contributed to the activity (or used to purchase
     property which is contributed to the activity) are
     "amounts borrowed with respect to" the activity (as
     referred to in section 465(b)(1)(B)) and therefore are
     subject to the rules of section 465(b)(3) even though
     amounts (or property) are also described in section
     465(b)(1)(A). [Staff of the Joint Comm. on Taxation,
     General Explanation of the Tax Reform Act of 1976, at
     39 n.12 (J. Comm. Print 1976).]

The General Explanation is in accord with our own conclusion as

to the operation of the statute.   In short, petitioners fail to

marshal any meaningful support for their argument under section

465(b)(1)(A).   Accordingly, we hold that the loan does not,

without consideration of section 465(b)(1)(B), constitute money

contributed to an activity under section 465(b)(1)(A).

Section 465(b)(1)(B)

     Petitioners additionally contend that the loan should be

considered at risk pursuant to section 465(b)(1)(B).   Petitioners

argue that the loan is not subject to the general prohibition of

section 465(b)(3)(A) against borrowing from parties with an

interest in the activity because of the exception provided by

section 465(b)(3)(B)(ii).   Petitioners argue:

     Van Wyk loaned funds to West View, thus fulfilling the
     first clause of I.R.C. § 465(b)(3)(B)(ii). ("In the
     case of amounts borrowed by a corporation from a
     shareholder . . ."). Because this requirement is met,
     Roorda's status as a shareholder is disregarded and
     I.R.C. § 465(b)(3) does not apply. Since Van Wyk was
                               - 11 -

     personally liable to repay the loan to Roorda, I.R.C. §
     465(b)(2) has been satisfied and Van Wyk has amounts
     "at risk" under I.R.C. § 465(b)(1)(B).

In essence, petitioners argue that section 465(b)(3)(B)(ii) is

meant to allow at-risk status for a shareholder who borrows money

from another shareholder and then lends it to a corporation owned

by both of the shareholders.   Respondent contends that section

465(b)(3)(B)(ii) bears only upon the at-risk status of a

corporation, not its shareholders.

     We agree with respondent that the proper interpretation is

that section 465(b)(3)(B)(ii) applies only to allow at-risk

status for a corporate borrower, not to an individual shareholder

merely because he made the loan in question to his corporation.

Section 465(b)(1)(B) and (2) speaks to amounts borrowed by a

taxpayer–-in the instant case, the reference to a taxpayer is to

petitioner.   Section 465(b)(3)(A) prohibits at-risk treatment for

those amounts, i.e., the amounts borrowed by the taxpayer (in the

instant case petitioner), if those amounts are borrowed from a

person with an interest in the activity or from a person related

to such a person.   Section 465(b)(3)(B)(i) excepts those borrowed

amounts, i.e., allows at-risk treatment, where the only interest

in the activity possessed by the lender (the person from whom the

taxpayer borrowed the money) is a creditor's interest.   That

exception does not apply to the instant case because Keith

Roorda's interest in the activity is an equity interest, which is
                              - 12 -

a prohibited interest.3   Moreover, Linda Roorda, as the wife of

Keith Roorda, is a "related person to a person with an interest

in the activity" within the meaning of section 465(b)(3)(A).4      As

we read section 465(b)(3)(B)(ii), it excepts borrowed amounts

only where the borrower that is claiming to be at risk on those

amounts is a corporation.5   In the instant case, because the


3
     In Jackson v. Commissioner, 86 T.C. 492, 529 (1986), affd.
864 F.2d 1521 (10th Cir. 1989), we held that a prohibited
interest is a capital interest in the activity or an interest in
the net profits of the activity. We have applied the holding in
Jackson in later cases. See Levy v. Commissioner, 91 T.C. 838,
868 (1988); Larsen v. Commissioner, 89 T.C. 1229, 1270 (1987),
affd. in part and revd. on another issue sub nom. Casebeer v.
Commissioner, 909 F.2d 1360 (9th Cir. 1990); Bennion v.
Commissioner, 88 T.C. 684, 698 (1987). In these cases, we
defined a capital interest as an interest in the assets of the
activity which is distributable to the owner of the capital
interest upon liquidation of the activity.
4
     "Related person" includes a spouse.   See secs. 465(b)(3)(C),
267(b)(1) and (c)(4).
5
     Put more technically, the following analysis was set forth
in respondent's brief:

     "Taxpayer" in * * * paragraph 465(b)(1) is the
     antecedent to which "amounts borrowed by a corporation"
     found in subparagraph 465(b)(3)(B)(ii) refers. The
     clause "amounts borrowed by a corporation" found in
     subparagraph 465(b)(3)(B)(ii) relates back to the
     phrase "amounts borrowed" found in subparagraph
     465(b)(3)(A). The phrase "amounts borrowed" found in
     subparagraph 465(b)(3)(A) relates back to the phrase
     "amounts borrowed" found in subparagraph 465(b)(1)(B).
     The phrase "amounts borrowed" found in subparagraph
     465(b)(1)(B) relates back to the term "taxpayer" found
     in both * * * paragraph 465(b)(1) and paragraph
     465(b)(2). This * * * [syntactical] analysis reveals
     the clause "by a corporation" to be a term of
                                                    (continued...)
                             - 13 -

taxpayer claiming to be at risk for the borrowed amounts is an

individual, section 465(b)(3)(B)(ii) does not apply.

     The House report accompanying the enactment of the Deficit

Reduction Act of 1984 (DEFRA), Pub. L. 98-369, sec. 432(c), 98

Stat. 494, 814, the act which added section 465(b)(3)(B)(ii) to

the Code, supports our reading of section 465.   The House report

states:

     Borrowing from related parties

     The bill provides that recourse borrowing from related
     parties (including family members and entities
     controlled by the taxpayer) may be considered at risk
     for purposes of the loss limitation and investment tax
     credit at-risk rules. Except as otherwise provided by
     regulations, recourse borrowing will be considered not
     at risk when the related party has an interest (other
     than as a creditor) in the activity or when the
     taxpayer is otherwise protected against loss. The bill
     also specifies that a corporation may be considered at
     risk with respect to amounts borrowed from its
     shareholders to finance participation in an activity.
     [H. Rept. 98-432 (Part 2), at 1514-1515 (1984);
     emphasis added.6]

5
 (...continued)
     limitation to the more general "taxpayer" found in §
     465(b)(2), * * * to which § 465(b)(3)(B) refers.

Respondent's analysis comports with our own analysis above.
6
     The Staff of Joint Committee on Taxation, General
Explanation of the Revenue Provisions of the Deficit Reduction
Act of 1984, at 736 (J. Comm. Print 1984), contains nearly
identical language:

     The Act further provides that, except to the extent
     provided in regulations, recourse borrowing will not be
     considered at risk where the lender has an interest
                                                   (continued...)
                              - 14 -

The quoted passage indicates that a corporation may be at risk

for amounts borrowed from its shareholders by reason of section

465(b)(3)(B)(ii).   Yet we can find no legislative history

suggesting that the shareholders will be deemed at risk with

respect to such amounts by reason of that provision of the

statute.

      Petitioners contend that if Congress intended the exception

of section 465(b)(3)(B)(ii) to apply only to corporations, i.e.,

only at the corporate level, it would have expressly provided

that the exception applied only for purposes of calculating

corporate-level at risk amounts.   Petitioners further contend

that, because there is no express language in section

465(b)(3)(B)(ii) limiting its application only to corporations,

the statute should be construed to afford them relief.   Indeed,

if the statute contained such language, our task would have been

simpler.   The failure of the statute to contain such language,

however, does not persuade us that our interpretation is

incorrect.




6
 (...continued)
     (other than as a creditor) in the activity or is
     related to a person (other than the taxpayer) having
     such an interest. However, the Act specifies that a
     corporation may be considered at risk with respect to
     amounts borrowed from its shareholders to finance
     participation in an activity.
                              - 15 -

     Additionally, we note that 2 years after section 465(a)(1)

was amended to eliminate the at-risk limitations for S

corporations,7 section 465(b)(3)(B)(ii) was added to the Code by

DEFRA section 432(c).   The logical inference, therefore, is that,

because the at-risk status of an S corporation is no longer

relevant, where section 465(b)(3)(B)(ii) addresses the at-risk

status of a corporation borrowing from its shareholders, the

statute must refer only to C corporations that are subject to

section 465.

     For the reasons stated above, we simply are not persuaded by

petitioners' arguments or their interpretation of the statute.

Accordingly, we hold that, because the source of the funds

constituting the loan is not excepted by section

465(b)(3)(b)(ii), petitioner, pursuant to section 465(b)(3)(A),

is not considered to be at risk with respect to the loan.




7
     Previously, with respect to S corporations, the at-risk
limitations of sec. 465(a)(1) applied at both the corporate and
the shareholder level. Sec. 5(a)(31)(A) of the Subchapter S
Revision Act of 1982, Pub. L. 97-354, 96 Stat. 1669, 1695,
however, amended sec. 465(a)(1) by eliminating the at-risk
limitations for S corporations. See also H. Rept. 98-432 (Part
2), at 1507 ("In the case of a[n] * * * S corporation, the [at-
risk] rules apply at shareholder level."), 1507 n.16 (The at-risk
"provisions no longer apply at the corporate level as a result of
an amendment made by the subchapter S Revision Act of 1982 (Pub.
L. 97-354)" (1984).
                               - 16 -

Section 6662(a)

     The final issue is whether petitioners are liable for a

penalty under section 6662.    Section 6662(a) imposes a 20-percent

penalty on the portion of an underpayment of tax that is

attributable to, inter alia, any substantial understatement of

income tax.    A substantial understatement of tax is defined as

the amount which exceeds the greater of 10 percent of the tax

required to be shown on the return for the taxable year or

$5,000.   See sec. 6662(d)(1)(A).   An understatement is reduced to

the extent it is:    (1) Based upon substantial authority; (2)

adequately disclosed in the tax return or in a statement attached

to the return and there was a reasonable basis for the treatment

of the item.   See sec. 6662(d)(2)(B).    Petitioners must establish

error in respondent's determination that they are liable for the

penalty provided by section 6662(a).     See Rule 142(a).

     The section 6662 penalty does not apply to any portion of an

underpayment where it is shown that there was reasonable cause

and that the taxpayer acted in good faith.     Sec. 6664(c)(1).   The

decision as to whether the taxpayer acted with reasonable cause

and in good faith depends upon all pertinent facts and

circumstances.    Sec. 1.6664-4(b)(1), Income Tax Regs.     Under the

circumstances of the instant case, we believe that the complexity

of section 465, and the lack of express guidance in the

regulations, led petitioners to an honest mistake of law for
                             - 17 -

which it is inappropriate to penalize them.    Accordingly, we do

not sustain the section 6662 determination by respondent.

     To reflect the foregoing,


                                      Decision will be entered

                                 under Rule 155.
