                         T.C. Memo. 2008-246



                       UNITED STATES TAX COURT



         DONALD L. AND EVELYN RUSSELL, ET AL.,1 Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 4425-05, 4456-05,         Filed October 30, 2008.
                 4688-05.



     Jon J. Jensen, for petitioners.

     Jack Forsberg, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     HAINES, Judge:    These cases are before the Court

consolidated for purposes of trial, briefing, and opinion.

Donald and Evelyn Russell (the Russells), Loren and Dawn Kopseng



     1
      Cases of the following petitioners are consolidated
herewith: Loren R. and Dawn Kopseng, docket No. 4456-05; United
Energy Corp., docket No. 4688-05.
                              - 2 -

(the Kopsengs), and United Energy Corp. separately petitioned the

Court for redetermination of the following deficiencies in

Federal income tax:

          Donald L. & Evelyn Russell, docket No. 4425-05

                 TYE                    Deficiency

             12/31/1997                  $128,414



          Loren R. & Dawn Kopseng, docket No. 4456-05

                 TYE                    Deficiency

             12/31/1997                  $278,340



          United Energy Corp., docket No. 4688-05

                 TYE                    Deficiency

             6/30/1998                   $437,698

     The issue for decision after concessions is whether

instruments entitled “notes”, “ledger debt”, and “short-term

debt” constituted “indebtedness of the S corporation to the

shareholder” for purposes of determining whether petitioners

Donald Russell (Mr. Russell) and Loren Kopseng (Mr. Kopseng) had

sufficient basis under section 1366(d)(1)(B) to claim their

distributive shares of the loss incurred by Missouri River

Royalty Corp.2


     2
      Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended, and all Rule references
                                                   (continued...)
                                  - 3 -

                          FINDINGS OF FACT

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

The stipulation of facts and the supplemental stipulation of

facts, together with attached exhibits, are incorporated herein

by this reference.    At the time the Russells and Kopsengs filed

their petitions, they resided in North Dakota.       At the time

United Energy Corp. (UEC) filed its petition, its principal place

of business was in North Dakota.

      On May 18, 2005, respondent sent petitioners notices of

deficiency for the years at issue.        Petitioners filed timely

petitions with this Court.

I.    Members of the UEC Group and Predecessor Entities

      A.    United Energy Corp.

      UEC was incorporated under the law of North Dakota on August

29, 1997.    At all times since its incorporation, UEC has used the

accrual method of accounting for tax and financial reporting

purposes and has had a fiscal year and taxable year ending June

30.   At all times from the initial issuance of stock by UEC on

September 1, 1997, through June 30, 1998, all of UEC’s

outstanding stock was owned by Mr. Russell and Mr. Kopseng.

      UEC timely filed a Form 1120, U.S. Corporation Income Tax

Return, for its initial short taxable year beginning September 1,


      2
      (...continued)
are to the Tax Court Rules of Practice and Procedure.       Amounts
are rounded to the nearest dollar.
                                 - 4 -

1997, and ending June 30, 1998.    UEC filed its Form 1120 as the

common parent of a consolidated group of corporations consisting

of itself, Rainbow Gas Co. (RGC), Rainbow Energy Marketing Corp.

(REMC), Missouri River Royalty Corp (MRRC), and Energy Leasing

Corp. (ELC).

     B.    Rainbow Gas Co.

     Before 1997 the assets of RGC were owned by a North Dakota

limited partnership (RGC Partnership).   As of August 29, 1997,

all of the general and limited partnership interests in RGC

Partnership were owned by Mr. Russell and Mr. Kopseng.    On August

29, 1997, in a transaction qualifying as a tax-free exchange

under section 351(a), all the assets of RGC Partnership were

transferred to RGC, a newly formed North Dakota corporation, in

exchange for the issuance of 375 shares of RGC stock to Mr.

Russell and 625 shares of RGC stock to Mr. Kopseng.    The RGC

shares issued to Mr. Russell and Mr. Kopseng constituted all of

the outstanding shares of RGC.

     C.    Rainbow Energy Marketing Corp.

     REMC is a North Dakota corporation.    As of September 1,

1997, REMC had 4,512,205 shares outstanding, of which 1,108,056

were owned by Mr. Russell and 2,701,149 were owned by Mr.

Kopseng.
                                - 5 -

      D.   Missouri River Royalty Corp.

      MRRC is a North Dakota corporation which was incorporated on

September 7, 1984.    At all times before September 1, 1997, MRRC

was an S corporation.    Effective September 1, 1997, MRRC

voluntarily revoked its S corporation election.    MRRC filed a

Form 1120S, U.S. Income Tax Return for an S Corporation, for the

short taxable year beginning January 1, 1997, and ending August

31, 1997.    At all relevant times before September 1, 1997, MRRC

had 30,000 shares outstanding, of which Mr. Russell and Mr.

Kopseng each owned 15,000 shares.

II.   The Section 351 Transaction

      On September 1, 1997, Mr. Russell received 350 shares of UEC

stock and Mr. Kopseng received 650 shares of UEC stock as part of

a transaction qualifying as a tax-free exchange under section

351(a).    As part of the section 351 transaction, Mr. Russell made

a contribution to UEC of 375 shares of RGC stock, 1,108,056

shares of REMC stock, and 15,000 shares of MRRC stock.    Mr.

Kopseng made a contribution to UEC of 625 shares of RGC stock,

2,701,149 shares of REMC stock, and 15,000 shares of MRRC stock.

      UEC’s audited consolidated financial statement for the

period ending June 30, 1998, contained the following statement

respecting the section 351 transaction:

           In August, 1997 United Energy Corporation (the
      company) exchanged 1,000 shares of its common stock for
      100% of the shares of Rainbow Gas Company and Missouri
      River Royalty and 85% of the outstanding shares of
                               - 6 -

     Rainbow Energy Marketing Corporation. This transaction
     was accounted for under the requirements of
     interpretation 39 of Accounting Standards Board Opinion
     #16, whereby the acquisitions were treated as a
     transfer of shares between companies with common
     control in a manner similar to a pooling of interest.
     Accordingly, all assets and liabilities of the merged
     companies were recognized at historical cost and the
     historical financial statements of Rainbow Gas Company,
     Missouri River Royalty Corporation and Rainbow Energy
     Marketing Corporation became a component of the
     historical financial statements of the company.

The audited financial statement made no reference to any

assumption or contribution of liabilities being part of the

section 351 transaction.

     In their capacities as the incorporators and directors

of UEC, Mr. Russell and Mr. Kopseng executed a Consent to Action

Taken in Lieu of Organizational Meeting dated September 3, 1997

(consent).   With respect to the section 351 transaction, the

consent stated as follows:

          The directors were authorized to issue stock
     pursuant to the attached Resolution in the amount of
     650 shares to Loren R. Kopseng in return for his
     contribution of shares from Rainbow Gas Company,
     Missouri River Royalty Corporation, and Rainbow Energy
     Marketing Corporation, and has [sic] been authorized to
     issue 350 shares to Donald L. Russell in return for his
     contribution of shares from Rainbow Gas Company,
     Missouri River Royalty Corporation, and Rainbow Energy
     Marketing Corporation.

The consent made no reference to any assumption or contribution

of liabilities being part of the section 351 transaction.
                               - 7 -

     In their capacities as the directors and officers of UEC,

Mr. Russell and Mr. Kopseng executed a resolution dated September

3, 1997.   The resolution stated:

          Loren R. Kopseng has transferred 625 shares of
     Rainbow Gas Company stock, 2,701,149 shares of Rainbow
     Energy Marketing Corporation stock, and all shares of
     Missouri River Royalty Corporation stock to United
     Energy Corporation. In return for the transfer of
     these shares, United Energy Corporation is hereby
     authorized to issue 650 shares of United Energy
     Corporation’s stock to Loren R. Kopseng.
          Donald L. Russell has transferred 375 shares of
     Rainbow Gas Company stock, 1,108,056 shares of Rainbow
     Energy Marketing Corporation stock, and all shares of
     Missouri River Royalty Corporation stock to United
     Energy Corporation. In return for the transfer of
     these shares, United Energy Corporation is hereby
     authorized to issue 350 shares of United Energy
     Corporation’s stock to Donald L. Russell.

     The resolution made no reference to any assumption or

contribution of liabilities being part of the section 351

transaction.

III. Financial Instruments of the UEC Group

     MRRC required capital to purchase and rework oil wells.

Petitioners acquired capital for MRRC through a variety of

transactions.

      A.   The BNC Notes

     On or about August 16, 1996, BNC National Bank (BNC) lent $1

million to MRRC.   MRRC used the proceeds of the loan to pay off

certain prior loans that had been incurred to purchase and rework

oil wells.   In consideration for the loan, MRRC gave BNC a
                                - 8 -

promissory note for $1 million (MRRC note) and entered into a

loan agreement.

     The MRRC note bore interest at the Wall Street Journal prime

rate plus 2 percent and required 47 monthly payments of $25,552

and a balloon payment of all remaining principal and interest on

August 16, 2000.    Mr. Russell and Mr. Kopseng cosigned the MRRC

note.    Throughout the life of the loan, interest on the MRRC note

was calculated using monthly compounding and an interest rate of

10.25 percent.    At all times from August 16, 1996, through

January 3, 1997, the Wall Street Journal prime rate was 8.25

percent.

     As of January 3, 1997, the principal balance of the MRRC

note was $927,936.    On January 3, 1997, BNC canceled the MRRC

note in consideration for (1) a $463,968 promissory note which

Mr. Russell cosigned (the MRRC/DR note), and (2) a $463,968

promissory note which Mr. Kopseng cosigned (the MRRC/LK note).

Mr. Russell and Mr. Kopseng also indicated that they intended to

guarantee the MRRC/DR note and the MRRC/LK note.3

     The MRRC/DR note and the MRRC/LK note both listed MRRC as

the borrower and indicated that they were for the renewal of the

MRRC note.    The MRRC/DR note and the MRRC/LK note both bore

interest at the Wall Street Journal prime rate plus 2 percent and


     3
      Both the MRRC/DR note and the MRRC/LK note state that they
are “guarantied with the personal guarantys [sic] of Donald L.
Russell and Loren Kopseng dated 1/3/97.”
                                - 9 -

required 44 monthly payments of $12,776 and a balloon payment of

the remaining principal and interest on August 16, 2000.    Through

March 27, 1997, interest on both the MRRC/DR note and the MRRC/LK

note was calculated using an interest rate of 10.25 percent.

After March 27, 1997, interest was calculated using an interest

rate of 10.50 percent.   Interest on both the MRRC/DR note and the

MRRC/LK note was calculated using monthly compounding.   The Wall

Street Journal prime rate was 8.25 percent from January 3, 1997,

through March 26, 1997, and 8.5 percent from March 27, 1997,

through September 29, 1998.

     Between January 3 and September 3, 1997, MRRC made 8 monthly

payments of $12,776 on the MRRC/DR note and 8 monthly payments of

$12,776 on the MRRC/LK note.   All monthly payments on the MRRC/DR

note and on the MRRC/LK note were applied first to interest and

then to principal.

     The interest which accrued on the MRRC/DR note and on the

MRRC/LK note between January 3 and September 3, 1997, was as

follows:

        Interest
     Accrued Through     MRRC/DR Note    MRRC/LK Note      Total

     Sept. 1, 1997         $30,009         $30,009       $60,018
     Sept. 3, 1997          30,217          30,217        60,434

     As of September 1 and September 3, 1997, the principal

balances of the MRRC/DR note and the MRRC/LK note were as

follows:
                               - 10 -

          Principal Balance      MRRC/DR Note     MRRC/LK Note

           Sept. 1, 1997           $389,915         $389,915
           Sept. 3, 1997            389,915          389,915

     On September 3, 1997, using a telephone transfer, MRRC paid

BNC (1) the $389,915 principal balance of the MRRC/DR note, (2)

the $389,915 principal balance of the MRRC/LK note, (3) the

accrued interest of $2,042 on the MRRC/DR note, and (4) the

accrued interest of $2,042 on the MRRC/LK note.

     The $60,434 of interest that was accrued and paid on the

MRRC/DR note and MRRC/LK note was reported on the 1998 UEC Form

1120 as an interest expense of MRRC.    None of the $60,434 was

reported on Mr. Russell’s 1997 Form 1040, U.S. Individual Income

Tax Return, or Mr. Kopseng’s 1997 Form 1040, either as interest

income or as an interest expense.

     As of September 1 and September 3, 1997, the fair market

value of the MRRC/DR note was equal to the MRRC/DR note’s

principal balance of $389,915.    As of September 1, 1997, and as

of September 3, 1997, the fair market value of the MRRC/LK note

was equal to the MRRC/LK note’s principal balance of $389,915.

     B.     The Russell and Kopseng Ledger Debt

     Before April 5, 1996, Mr. Russell made a series of cash

advances to MRRC which MRRC used for working capital (the Russell

ledger debt).    As of April 5, 1996, the principal balance of

these advances totaled $562,705.    In MRRC’s books, the Russell

ledger debt was recorded as a liability in a ledger account
                              - 11 -

entitled “Notes Payable Russell” (the notes payable Russell

account).

     On April 5, 1996, MRRC issued a $562,705 note to Mr. Russell

for the Russell ledger debt (the Russell ledger debt note).     As

of September 1, 1997, the principal balance of the Russell ledger

debt was $65,527.

     Before April 5, 1996, Mr. Kopseng made a series of cash

advances to MRRC which MRRC used for working capital (the Kopseng

ledger debt).   As of April 5, 1996, the principal balance of

these advances totaled $611,144.   In MRRC’s books, the Kopseng

ledger debt was recorded as a liability in a ledger account

entitled “Notes Payable Kopseng” (the notes payable Kopseng

account).

     On April 5, 1996, MRRC issued a $611,144 note to Mr. Kopseng

for the Kopseng ledger debt (the Kopseng ledger debt note).     As

of September 1, 1997, the principal balance of the Kopseng ledger

debt was $117,438.

     The Russell ledger debt and the Kopseng ledger debt were

demand obligations.   Interest on the Russell ledger debt and the

Kopseng ledger debt was calculated using monthly compounding.

There was no requirement that interest accruing on the Russell

ledger debt and Kopseng ledger debt be paid at least annually.

     As of September 1, 1997, the fair market value of the

Russell ledger debt was equal to the Russell ledger debt’s
                                - 12 -

principal balance of $65,527.    Likewise, the fair market value of

the Kopseng ledger debt was equal to the Kopseng ledger debt’s

principal balance of $117,438.

     Respondent concedes that the Russell ledger debt and the

Kopseng ledger debt constituted indebtedness of MRRC to Mr.

Russell and Mr. Kopseng for purposes of section 1366(d)(1)(B).

     C.   The REMC Ledger Debt

     REMC lent MRRC $57,000 on April 1, 1996, and $37,000 on

April 11, 1996 (REMC ledger debt).       MRRC used the REMC ledger

debt for working capital.    In MRRC’s books, the REMC ledger debt

was recorded as a liability in a ledger account entitled “Notes

Payable Kopseng/Russell Partnership.”       The REMC ledger debt was a

demand obligation.   There was no requirement that interest

accruing on the REMC ledger debt be paid at least annually.

     A note was prepared in connection with the REMC ledger debt

(the REMC note).   The REMC note stated, in part, that “Effective

April 1, 1996, Missouri River Royalty Corporation promises to pay

Kopseng/Russell Partnership $94,000.00 at an interest rate of the

applicable Federal Rate Table.”    Interest on the REMC ledger debt

was in fact calculated at a rate that varied from the Wall Street

Journal Prime Rate plus 1 percent to the Wall Street Journal

Prime Rate plus 2 percent.   Interest on the REMC ledger debt was

calculated using monthly compounding.       At all times, the rates

used to calculate interest on the REMC ledger debt exceeded the
                                - 13 -

short-term, monthly-compounding Applicable Federal Rate as then

in effect.    There was no requirement that interest accruing on

the REMC ledger debt be paid at least annually.

     As of September 1, 1997, the principal balance of the REMC

ledger debt was $75,750.

     On June 30, 1998, an adjusting journal entry to MRRC’s books

reclassified $22,042 of the $75,750 balance of the REMC ledger

debt to the notes payable Russell account and $53,708 of the

balance to the notes payable Kopseng account.    The adjusting

journal entry allocated the balance of the REMC ledger debt

between the notes payable Russell account and the notes payable

Kopseng account in proportion to the interests held by Mr.

Russell and Mr. Kopseng in REMC at the time the loans were made

in April of 1996.

     As of September 1, 1997, the fair market value of the REMC

ledger debt was equal to the REMC ledger debt’s principal balance

of $75,750.

     D.   The Short-Term Debt

     During the period between March 7, 1997, and June 16, 1997,

MRRC received a series of loans totaling $1,830,597 (short-term

debt) as follows:
                              - 14 -

               Date                 Amount Borrowed

           Mar. 7, 1997                  $300,500
           Mar. 13, 1997                  236,000
           Mar. 14, 1997                   20,000
           Apr. 2, 1997                   447,750
           Apr. 4, 1997                     8,200
           Apr. 29, 1997                  336,000
           May 15, 1997                     2,500
           June 3, 1997                   455,647
           June 16, 1997                   24,000
             Total                      1,830,597

MRRC used the proceeds of the short-term debt for working

capital.

     Between May 13, 1997, and August 27, 1997, MRRC repaid

$629,000 of principal on the short-term debt as follows:

               Date                 Amount Repaid

           May 13, 1997                 $200,000
           July 3, 1997                  165,000
           Aug. 15, 1997                  90,000
           Aug. 25, 1997                 200,000
           Aug. 27, 1997                  37,000
             Total                       692,000

No interest was paid on the short-term debt before September 3,

1997.

     The loans making up the short-term debt were transferred

directly from the checking account of RGC Partnership to the

checking account of MRRC.   The repayments were transferred

directly from the checking account of MRRC to the checking

account of RGC Partnership.   Before August 31, 1997, the short-

term debt was recorded in MRRC’s books as a liability in a ledger

account entitled “Notes Payable RGC”.    As of August 31, 1997, an
                                - 15 -

adjusting journal entry to MRRC’s books reclassified $569,298 of

the short-term debt to the notes payable Kopseng account and

$569,298 to the notes payable Russell account.

     With respect to each of the nine loans comprising the short-

term debt, four notes were prepared:     (1) One from Mr. Russell to

RGC Partnership (Russell/RGC notes), (2) one from Mr. Kopseng to

RGC Partnership (Kopseng/RGC notes), (3) one from MRRC to Mr.

Russell (MRRC/Russell notes), and (4) one from MRRC to Mr.

Kopseng (MRRC/Kopseng notes).    The face amount of each note was

half of the amount transferred from RGC Partnership to MRRC on

the date of the respective transfer.

     The face amounts of the Russell/RGC notes, the Kopseng/RGC

notes, the MRRC/Russell notes, and the MRRC/Kopseng notes

(collectively the short-term notes) were set forth as follows:

                         Short-Term Debt
                     Date Lent           Amount

                    March 7, 1997         $300,500
                    March 13, 1997         236,000
                    March 14, 1997          20,000
                    April 2, 1997          447,750
                    April 4, 1997            8,200
                    April 29, 1997         336,000
                    May 15, 1997             2,500
                    June 3, 1997           455,647
                    June 16, 1997           24,000
                      Total              1,830,597
                               - 16 -

                Face Amount of Shareholder/RGC Notes
                 Russell to RGC      Kopseng to RGC

                    $150,250            $150,250
                     118,000             118,000
                      10,000              10,000
                     223,875             223,875
                       4,100               4,100
                     168,000             168,000
                       1,250               1,250
                     227,823             227,823
                      12,000              12,000
                     915,298             915,298


                Face Amount of MRRC/Shareholder Notes
                 MRRC to Russell     MRRC to Kopseng

                    $150,250            $150,250
                     118,000             118,000
                      10,000              10,000
                     223,875             223,875
                       4,100               4,100
                     168,000             168,000
                       1,250               1,250
                     227,823             227,823
                      12,000              12,000
                     915,298             915,298

     Each of the short-term notes bore an “effective” date which

was identical to the date on which the corresponding loan was

made to MMRC.   Both Mr. Kopseng and Mr. Russell signed each of

the short-term notes, either in their individual capacities or on

behalf of RGC or MMRC, but none of their signatures were dated.

The short-term debt was a demand obligation.

     Each short-term note stated that it bore interest at “an

interest rate of the applicable Federal Rate Table.”    However,

interest on the short-term debt was calculated at a rate that

varied from the Wall Street Journal Prime Rate plus 1 percent to
                                - 17 -

the Wall Street Journal Prime Rate plus 2 percent.      Interest on

the short-term debt was calculated using monthly compounding.       At

all times, the rates used to calculate interest on the short-term

debt exceeded the short-term, monthly-compounding Applicable

Federal Rate as then in effect.     There was no requirement that

interest accruing on the short-term debt be paid at least

annually.

     As of September 1, 1997, and September 3, 1997, the

principal balance of, and the accrued interest on, the short-term

debt was as follows:

                    Date       Interest     Principal

               Sept. 1, 1997   $61,923     $1,138,597
               Sept. 3, 1997    62,578      1,138,597

     On September 3, 1997, the $1,138,597 principal balance of

the short-term debt, along with accrued interest thereon of

$62,578, was paid by using a $1,201,175 cashier’s check from MRRC

to RGC.     The $1,201,175 payment was reflected in MRRC’s books by

(1) debiting the notes payable Russell account for $569,298, (2)

debiting the notes payable Kopseng account for $569,298, and (3)

debiting the loan interest account for $62,578 with the memo

notation “Interest paid to Kopseng & Russell for Note.”     The

$1,201,175 payment was reflected in RGC’s books by (1) crediting

the “Notes Payable Don Russell” ledger account for $569,298, (2)

crediting the “Notes Payable Loren Kopseng” ledger account for
                              - 18 -

$569,298, and (3) crediting the interest income account for

$62,578 with the memo notation “Interest on Note Rec. from MRRC.”

      The $62,578 of accrued interest on the short-term debt was

reported on the 1998 UEC Form 1120 as an interest expense of MRRC

and interest income of RGC.   None of the $62,578 was reported on

Mr. Russell’s 1997 Form 1040 or Mr. Kopseng’s 1997 Form 1040,

either as interest income or interest expense.

      As of September 1, 1997, and as of September 3, 1997, the

fair market value of the short-term debt was equal to the short-

term debt’s principal balance of $1,138,597.

      The MRRC note, the MRRC/DR note, the MRRC/LK note, the

Russell ledger debt, the Kopseng ledger debt, the REMC ledger

debt, and the short-term debt were not “publicly offered” within

the meaning of that term as used in section 1273(b)(1), nor were

they property of the type described in section 1273(b)(3).

IV.   Russell and Kopseng’s Basis in Indebtedness and MRRC Stock

      As of the beginning of MRRC’s short taxable year ending

August 31, 1997, Mr. Russell’s basis in his MRRC stock was

$150,151, and Mr. Kopseng’s basis in his MRRC stock was zero.

      The MRRC 1997 Form 1120S reported an ordinary loss of

$1,117,540, interest income of $250, and dividend income of $208.

Consistent with the MRRC 1997 Form 1120S, the following items

from MRRC’s taxable year ended August 31, 1997, were reported on

Mr. Russell’s 1997 return and on Mr. Kopseng’s 1997 return.
                             - 19 -

                      Item                 Amount

                 Ordinary loss         $558,770
                 Interest income            125
                 Dividend income            104

     As of the end of MRRC’s taxable year ended August 31, 1997:

(1) Mr. Russell’s basis in the Russell ledger debt was $65,527

less the amount by which his basis in the Russell ledger debt was

properly reduced under section 1367(b)(2) on account of items of

MRRC for its taxable year ending August 31, 1997, and (2) Mr.

Kopseng’s basis in the Kopseng ledger debt was $117,438 less the

amount by which his basis in the Kopseng ledger debt was properly

reduced under section 1367(b)(2) on account of items of MRRC for

its taxable year ending August 31, 1997.

                             OPINION

     Petitioners contend that they had bases in certain

indebtedness of MRRC4 sufficient to permit them to deduct their

pro rata shares of MRRC’s ordinary loss of $1,117,540 for its

final, short taxable year ending August 31, 1997.   We disagree.

For the reasons set forth below, none of the MRRC Debts, save the

Russell ledger debt and Kopseng ledger debt, constituted

shareholder debt for purposes of section 1366(d)(1)(B).    We need

not decide whether the burden of proof shifts to respondent under




     4
      Namely the MRRC/DR note, the MRRC/LK note, the Russell
ledger debt, the Kopseng ledger debt, the REMC ledger debt, and
the short-term debt (collectively the MRRC Debts).
                              - 20 -

section 7491(a) because we decide this case on the basis of the

preponderance of the evidence.

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

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

corporation’s items of income, loss, deduction, or credit.

However, a shareholder may deduct his share of the S

corporation’s losses only to the extent of his adjusted basis in

his stock of the S corporation, sec. 1366(d)(1)(A), and “the

shareholder’s adjusted basis of any indebtedness of the S

corporation to the shareholder”, sec. 1366(d)(1)(B).    Any S

corporation losses so limited may be carried forward

indefinitely.   Sec. 1366(d)(2).

     The jurisprudence in this area has fleshed out certain

principles relating to the limitation set forth in section

1366(d)(1)(B) and the situations under which a shareholder

acquires basis with respect to indebtedness.   See Hitchins v.

Commissioner, 103 T.C. 711, 715 (1994); Grojean v. Commissioner,

T.C. Memo. 1999-425, affd. 248 F.3d 572 (7th Cir. 2001).    First,

a shareholder must make an actual economic outlay.     Underwood v.

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

(1975); Perry v. Commissioner, 54 T.C. 1293, 1296 (1970), affd.

27 AFTR 2d 71-1464, 71-2 USTC par. 9502 (8th Cir. 1971).5 The


     5
      The economic outlay requirement stems from the concept
that an S corporation shareholder should be entitled to basis to
                                                   (continued...)
                             - 21 -

economic outlay must leave the taxpayer “poorer in a material

sense” in order for its bona fides to be respected.     Perry v.

Commissioner, supra at 1296; see also Bergman v. United States,

174 F.3d 928, 933 (8th Cir. 1999)

     Second, the S corporation’s indebtedness must run directly

to the shareholder; an indebtedness to a passthrough entity that

advanced the funds and is closely related to the taxpayer does

not satisfy the statutory requirements.   Frankel v. Commissioner,

61 T.C. 343 (1973), affd. without published opinion 506 F.2d 1051

(3d Cir. 1974); Burnstein v. Commissioner, T.C. Memo. 1984-74.

Furthermore, no form of indirect borrowing, be it a guaranty,

surety, accommodation, comaking or otherwise, gives rise to

indebtedness from the corporation to the shareholders

until and unless the shareholders pay part or all of the




     5
      (...continued)
the extent of his investment in the S corporation. S. Rept.
1983, 85th Cong., 2d Sess. 219-220 (1958), 1958-3 C.B. 922, 1141
(“The amount of the net operating loss apportioned to any
shareholder * * * is limited under [former] section 1374(c)(2)
[the predecessor of sec. 1366(d)(1)] to the adjusted basis of the
shareholder’s investment in the corporation; that is, to the
adjusted basis of the stock in the corporation owned by the
shareholder and the adjusted basis of any indebtedness of the
corporation to the shareholder.”); see also Perry v.
Commissioner, 54 T.C. 1293, 1296 (1970) (concluding that
the word “investment” indicated an intent to limit a
shareholder’s basis to that shareholder’s "actual economic
outlay”), affd. 27 AFTR 2d 71-1464, 71-2 USTC par. 9502 (8th Cir.
1971).
                               - 22 -

existing obligation.   Before that crucial act, “liability” may

exist, but not debt to the shareholders.      Raynor v. Commissioner,

50 T.C. 762, 770-771 (1968).

I.   The MRRC/DR Note and the MRRC/LK Note

     Mr. Russell and Mr. Kopseng cosigned and guaranteed the

MRRC/DR note and the MRRC/LK note.      However, neither were

required to make any payments with respect to the MRRC notes.     In

the absence of any discernable economic outlay, Mr. Russell and

Mr. Kopseng’s cosigning and guaranteeing of the MRRC notes did

not give rise to “indebtedness of the S corporation to the

shareholder” under section 1366(d)(1)(B).      See Raynor v.

Commissioner, supra at 770 (holding that a shareholder’s guaranty

of a loan to an S corporation, in the absence of actual payments,

does not create indebtedness); Keech v. Commissioner, T.C. Memo

1993-71 (holding that a shareholder’s co-signing of a loan to an

S corporation may not be treated as an equity investment in the

corporation absent an economic outlay by the shareholder).

     Further, cosigning and guaranteeing the notes did not create

an indebtedness running directly from MRRC to Mr. Russell and Mr.

Kopseng.   MRRC’s only indebtedness ran to BNC.     The mere

possibility that MRRC could become obligated to Mr. Russell and

Mr. Kopseng at some future time is irrelevant for purposes of

determining indebtedness of the S corporation to the shareholder.

See Maloof v. Commissioner, 456 F.3d 645 (6th Cir. 2006), affg.
                              - 23 -

T.C. Memo. 2005-75.   Accordingly, Mr. Russell and Mr. Kopseng did

not obtain basis in the MRRC notes.

II.   The REMC Ledger Debt

      The REMC ledger debt was originally lent to MRRC in April

1996, by REMC, a C corporation owned by Mr. Russell and Mr.

Kopseng.   A loan to an S corporation by another entity owned by

the S corporation’s shareholder is not an indebtedness of the S

corporation to the shareholder.   See, e.g., Frankel v.

Commissioner, supra at 350 (holding that loans to an S

corporation from a partnership owned by the same shareholders

does not constitute indebtedness of the S corporation to the

shareholders); Burnstein v. Commissioner, supra (holding that

loans between two S corporations owned by the same shareholders

do not create a debt running directly to the shareholders).

Although the REMC ledger debt was eventually reclassified in

MRRC’s books on June 30, 1998, as notes payable to Mr. Russell

and Mr. Kopseng, the record is devoid of any evidence suggesting

that this treatment was intended at the time REMC made the loans.

Standing by itself, this adjustment of a journal entry several

years after the actual transaction is insufficient to reclassify

the source of a loan.   See Burnstein v. Commissioner, supra.

Because the REMC ledger debt did not run directly to Mr. Russell

and Mr. Kopseng, it did not increase their bases in MRRC.
                              - 24 -

III. The Short-Term Debt

     Respondent contends that the short-term debt should be

classified as a direct loan from RGC Partnership to MRRC.

Petitioners contend that the short-term debt constituted a series

of back-to-back loans from RGC Partnership to Mr. Russell and Mr.

Kopseng and from Mr. Russell and Mr. Kopseng to MRRC.   We agree

with respondent.

     The only evidence in the record supporting petitioners’

characterization consists of (1) the short-term notes themselves

and (2) the August 31, 1997, adjusting journal entry to MRRC’s

books reclassifying the short-term debt.   The four short-term

notes have little probative value as nothing in the record

indicates that they were executed contemporaneously with the nine

advances to MRRC.   Although each short-term note bears an

effective date which is identical to the date on which RGC

Partnership made a corresponding advance to MRRC, Mr. Russell’s

and Mr. Kopseng’s signatures on the notes are not themselves

dated, and petitioners failed to present evidence indicating when

the notes were executed.

     Petitioners’ reclassification of the short-term debt on

MRRC’s books is insufficient by itself to prove the loans’

origin.   The reclassification occurred on the last day of MRRC’s

final taxable year and only one day before the section 351
                               - 25 -

transaction.   Petitioners offered no explanation for the timing

of the reclassification.   Not being contemporaneous with

the actual advances, the adjusting journal entry cannot

establish that the short-term debt constituted back-to-back loans

at the time the advances were made.     See Burnstein v.

Commissioner, T.C. Memo. 1984-74.

     Finally, none of the interest paid on the short-term debt

was included in gross income or deducted as an expense by Mr.

Russell or Mr. Kopseng.    For these reasons, the short-term debt

is best characterized as a series of loans from RGC Partnership

to MRRC.   The issuance of the short-term debt did not constitute

an economic outlay by MRRC’s shareholders, and did not create

basis in MRRC stock.

     In reaching our holdings herein, we have considered all

arguments made, and, to the extent not mentioned above, we

conclude they are moot, irrelevant, or without merit.

     To reflect the foregoing,


                                           Decision will be entered

                                      under Rule 155 in docket Nos.

                                      4425-05, 4456-05, and 4688-05.
