                  T.C. Memo. 1999-425



                UNITED STATES TAX COURT



     THOMAS F. AND THERESE GROJEAN, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 14374-98.                Filed December 29, 1999.



     P organized A to acquire 100 percent of the stock
of S. To finance the purchase, A and S borrowed $13.2
million from the bank, and A and S signed a promissory
note in favor of the bank (the note). P was not a
party to the note. P contemporaneously borrowed $1.2
million from the bank and signed a note in favor of the
bank (P note), and P used the funds to purchase a $1.2-
million participation interest in the note. The note
and the P note had identical terms, and the bank
automatically credited amounts due under the P note
with amounts due P for his participation interest. No
cash changed hands, and all funds were electronically
credited at the bank. In calculating his allowable
distributive share of S losses for 1989, 1990, and
1991, P included in his basis $1.2 million for his
participation share. Held: In substance P functioned
as a guarantor of $1.2 million of the note, and P is
not entitled to include in his S basis the $1.2 million
participation interest. P did not make the requisite
                                 - 2 -

     cash outlay, and there was no direct obligation between
     P and S. Held, further, P’s are liable for the
     addition to tax for filing untimely their returns.

     Edward J. Hannon and Arthur M. Holtzman (specially

recognized), for petitioners.

     William T. Derick, for respondent.




              MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   Respondent determined the following

deficiencies in petitioners’ 1989 through 1991 Federal income tax

and additions thereto:

                                         Additions to Tax
           Year     Deficiency            Sec. 6651(a)(1)

           1989      $115,471                 $11,547
           1990       176,382                   8,819
           1991        11,570                     -

After concessions, we decide the following issues:

     1. Whether petitioner’s basis in his S corporation stock

under section 1366(d) includes his participation interest in a

loan between a bank and his S corporation.       We hold it does not.

     2.   Whether petitioners are liable for the additions to tax

determined by respondent.   We hold they are.

     Rule references are to the Tax Court Rules of Practice and

Procedure, and section references are to the Internal Revenue

Code as applicable to the years in issue.       Singular references to

petitioner are to Thomas F. Grojean.
                                - 3 -

                           FINDINGS OF FACT

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

The stipulation of facts and the exhibits submitted therewith are

incorporated herein by this reference.    Petitioner and Therese

Grojean are husband and wife, and they resided in Anderson,

Indiana, when they filed their petition in this case.

     Petitioner graduated from the University of Notre Dame in

1960 with a B.S. in accounting.    After college, he worked at

Price Waterhouse as a certified public accountant.    From 1968

through 1984, he was employed by Flying Tigers, an all-cargo

airline, where he was the chief financial officer and later the

chief operating officer.    In 1984, he left Flying Tigers to

acquire interests in several trucking companies.    American

National Bank and Trust Company of Chicago (American) financed

the acquisitions.

     As of 1989, Transamerica Leasing Company (Transamerica)

owned all the stock of Schanno Transportation, Inc. (Schanno), a

trucking company.   Sometime prior to July 13, 1989, petitioner

and Transamerica entered negotiations for petitioner’s possible

purchase of Schanno.   During these negotiations, petitioner

contacted American to discuss financing for the purchase.      In

August 1989, petitioner formed and became the sole shareholder of

Schanno Acquisition, Inc. (Schanno Acquisition), which he formed

for the purpose of acquiring Schanno.    The plan was for Schanno
                               - 4 -

Acquisition to merge with and into Schanno immediately after the

purchase.

     American agreed to lend $11 million to Schanno Acquisition

to finance the acquisition of Schanno if petitioner would

guarantee all loans personally.    Petitioner was unwilling to

undertake that risk, and the parties continued negotiations.

     On September 6, 1989, Schanno Acquisition executed a stock

purchase agreement (purchase agreement) wherein Schanno

Acquisition agreed to purchase all the stock of Schanno from

Transamerica for $13.9 million.    On the same date, American,

Schanno Acquisition, Schanno, and petitioner entered into a

comprehensive loan agreement (loan agreement) in which American

agreed to provide the following three loans to facilitate the

purchase:   (1) An $8.4-million loan to Schanno Acquisition and

Schanno (Schanno note), (2) a $2.6-million revolving credit loan

to Schanno Acquisition and Schanno (credit note), and (3) a $1.2-

million loan to petitioner (Grojean note).

     The loan agreement provided:

          (b) As a condition to [American’s] obligations to
     make the initial disbursements under the loans
     described herein, the following conditions shall have
     occurred and been approved to [American’s] reasonable
     satisfaction:

                *    *    *    *       *   *   *

                (iii) [American] and [petitioner] have
                                - 5 -

           entered into and delivered the Participation
           Agreement and [petitioner] has purchased, or
           will contemporaneously purchase, a portion of
           [American’s] interest in the [Schanno note]
           in the amount of One Million Two Hundred
           Thousand ($1,200,000) Dollars.

     Pursuant to the loan agreement, American disbursed to

Schanno Acquisition $8.4 million and $2.6 million under the

Schanno note and the credit note, respectively.   Both Schanno

Acquisition and Schanno signed the Schanno note and the credit

note, and both notes identified Schanno Acquisition and Schanno

as the borrowers or “makers”.   American was the only party

identified as the lender on the Schanno note and the credit note,

and petitioner was not a party to these notes.    Both loans were

secured by all the assets of Schanno.   Transamerica financed the

remainder of the purchase price, taking back a note from Schanno

Acquisition and Schanno for $2.9 million (Transamerica loan).

     Also on September 6, 1989, American advanced $1.2 million

to petitioner under the Grojean note by crediting this amount to

petitioner’s checking account at American.   Petitioner pledged

his stock in Schanno and Schanno Acquisition as security for the

loan.   Contemporaneous with execution of the Grojean note,

petitioner and American entered into a participation agreement

wherein petitioner agreed to purchase a $1.2-million
                               - 6 -

participation interest in the Schanno note.1   As pertinent, the

participation agreement provided:

          American hereby sells and Participant hereby
     purchases a participation in the *** [Schanno note], a
     copy of which is attached hereto and made a part hereof
     as Exhibit “A”. The purchase price is $1,200,000 and
     shall be paid to American upon the execution of this
     Agreement by Participant and American.

To cover the purchase price, American debited petitioner’s

checking account for $1.2 million.

     The Schanno note and the Grojean note each had identical

interest rates and were both 6-year notes with a due date of

September 1, 1995.   The Schanno note called for monthly payments

of principal, whereas the Grojean note did not require payment of

principal until the September 1, 1995, due date.    Both notes

called for monthly interest payments.

     The participation agreement provided that American’s

interest in the Schanno note was superior to petitioner’s

participation interest.   Petitioner became entitled to monthly

interest payments only upon payment of the interest by Schanno to

American under the Schanno note.    When American received a

monthly payment on the Schanno note, American credited

petitioner’s participating share to petitioner’s checking account


     1
      Petitioner’s offered rationale for this structure was that
he believed this would enable him to attain the same secured
status as American, whose security interest was superior to
Transamerica’s.
                               - 7 -

and contemporaneously debited the account for the interest

payments due under the Grojean note.   Petitioner was not entitled

to participate in any of the principal on the Schanno note until

American recovered its full share of principal.   After American

recovered its entire principal on the Schanno note, petitioner

became entitled to his share of principal as a credit against the

principal due on the Grojean note.

     American had sole authority and discretion to exercise its

rights under the Schanno note without the advice or consent of

petitioner, including authority to do all of the following:    (1)

Alter or modify the Schanno note or collateral agreement; (2)

release, substitute, or exchange collateral; (3) waive any

enforcement of any contractual terms against the borrower; or (4)

forbear from collection.   American issued to petitioner a

participation certificate evidencing petitioner’s ownership of a

$1.2 million participation interest in the Schanno note.     After

execution of the foregoing transactions, on September 6, 1989,

Schanno Acquisition merged with and into Schanno, leaving Schanno

as the surviving entity and petitioner as the sole shareholder.

     In October 1989, petitioner and American restructured the

Grojean note and the participation agreement by reducing the

Grojean note to $1 million and reducing petitioner’s
                               - 8 -

participating interest in the Schanno note to $1 million.   At the

same time, petitioner signed a $200,000 revolving credit note

(Grojean credit note), keeping the total amount he received in

the form of a loan at $1.2 million.    Petitioner then purchased a

$200,000-participation interest in the credit note.   Petitioner

and American amended the participation agreement to reflect this

purchase.2   The Grojean credit note had the same interest rate

and other terms as the credit note, and petitioner became

entitled to payments for his participation interest only when

American received payments under the credit note.   American's

share of the credit note was superior to petitioner’s $200,000

share.   American and petitioner amended other related documents

as well to incorporate these changes, including the loan

agreement and the stock pledge and security agreement.    American

had sole and absolute discretion to exercise any rights under the

credit note, without advice or consent from petitioner.    American

debited and credited interest payments to and from petitioner’s

checking account under the credit note and the Grojean credit

note as Schanno paid the amounts due under the Schanno note and

the credit note.

     For 1989, 1990, and 1991, American credited petitioner’s

checking account with interest income relating to his

participation interests in the Schanno note and the credit note


     2
      The record does not indicate whether American issued a
participation certificate to petitioner for his interest in the
credit note.
                               - 9 -

in the amounts of $31,875, $131,425, and $114,675, respectively.

For the same years, American debited interest payments due from

petitioner under the Grojean note and the Grojean credit note

from petitioner’s checking account for identical amounts, with

the net effect to petitioner for all years being a wash.

     As a condition of receiving their loans, Schanno, Schanno

Acquisition, and petitioner were required to give American annual

financial statements of Schanno that were audited and certified

by an independent accounting firm.     In the certified financial

statements that were prepared by the accounting firm for 1989,

1990, and 1991, Schanno reported that petitioner’s participation

interest was a $1.2-million guaranty of the corporation's $8.4

million loan and $2.6 million revolving credit loan.

     On his 1989, 1990, and 1991 Federal income tax returns,

petitioner claimed passthrough ordinary losses from Schanno in

the amounts of $1,186,375, $9,389, and $28,273, respectively.

Petitioners also claimed petitioner’s share of a net operating

loss carryforward from Schanno from 1989 to 1990 in the amount of

$591,245.   In applying the basis limitation under section

1366(d), he included in his basis $1.2 million representing his

participation interests in the Schanno note and the credit note.

Respondent disallowed the inclusion of that amount in

petitioner’s basis computation and determined that petitioner did

not have sufficient basis in his Schanno stock to allow for the
                               - 10 -

claimed losses.   Respondent disallowed the losses in full and

made other computational adjustments resulting from this

determination.

     Petitioners’ 1989 and 1990 Federal income tax returns were

due, with extensions, on October 15, 1990, and August 15, 1991,

respectively.    Petitioners filed those returns on December 13,

1990, and September 5, 1991, respectively.

                               OPINION

     We decide whether petitioner may increase his basis in

Schanno under section 1366(d) by the $1.2 million purchase price

of his participation interests in the Schanno note and the

Schanno credit note.   Respondent argues that petitioner received

no basis on account of his participation interests because the

Grojean note and the Grojean credit note were disguised

guaranties, and petitioner did not make the requisite economic

outlay.   Alternatively, respondent argues that the Grojean note

and the credit note were an integral part of interrelated

transactions having no independent economic substance.     We agree

with respondent that petitioner functioned as if he were a

guarantor of Schanno’s indebtedness to American, and petitioner

is not entitled to a basis increase for the guaranty.

     Section 1366(a) requires a taxpayer to take into account the

pro rata share of income, losses, and deductions of an S

corporation of which the taxpayer is a shareholder.   The losses
                               - 11 -

and deductions taken into account are limited by section 1366(d)

as follows:

     (d) Special Rules for Losses and Deductions.--

          (1) Cannot exceed shareholder's basis in stock and
     debt.--The aggregate amount of losses and deductions
     taken into account by a shareholder under subsection
     (a) for any taxable year shall not exceed the sum of–

               (A) the adjusted basis of the
          shareholder's stock in the S corporation
          * * *, and

               (B) the shareholder's adjusted basis of
          any indebtedness of the S corporation to the
          shareholder * * *.

Any S corporation loss that exceeds a taxpayer's adjusted basis

in his or her stock and debt is carried over indefinitely to the

succeeding years.   See sec. 1366(d)(2).

     Prior cases have established certain principles in respect

of the application of the indebtedness limitation under section

1366(d)(1)(B).   First, a taxpayer must make an actual economic

outlay.   See Underwood v. Commissioner, 535 F.2d 309 (5th Cir.

1976), affg. 63 T.C. 468 (1975); Hitchins v. Commissioner, 103

T.C. 711 (1994).    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.    See

Frankel v. Commissioner, 61 T.C. 343 (1973), affd. without

published opinion 506 F.2d 1051 (3d Cir. 1974); Prashker v.
                               - 12 -

Commissioner, 59 T.C. 172 (1972).

     To make an economic outlay, the shareholder must be left

poorer in a material sense after the transaction has been fully

consummated.   See Perry v. Commissioner, 54 T.C. 1293, 1296

(1970), affd. per order (8th Cir., May 12, 1971).   A shareholder

does not acquire basis by acting as guarantor, surety, or

accommodation party with respect to his corporation’s borrowing

from a third party until the shareholder pays part or all of the

obligation.    See Brown v. Commissioner, 706 F.2d 755, 757 (6th

Cir. 1983), affg. T.C. Memo 1981-608; Estate of Leavitt v.

Commissioner, 90 T.C. 206, 211 (1988), affd. 875 F.2d 420 (4th

Cir. 1989); Underwood v. Commissioner, 63 T.C. at 468-469; Raynor

v. Commissioner, 50 T.C. 762, 770-771 (1968); Perry v.

Commissioner, 47 T.C. 159 (1966), affd. 392 F.2d 458 (8th Cir.

1968).

     Here, the interrelated transactions show petitioner was in

substance a guarantor of the indebtedness between Schanno and

American.   The effect of all the transactions was that petitioner

would not be out-of-pocket unless and until Schanno failed to

make payments under the Schanno note or the credit note.    The

substance of a transaction will control over its form.   See

Gregory v. Helvering, 293 U.S. 465, 469-470 (1935); Spencer v.

Commissioner, 110 T.C. 62 (1998).

     Petitioner acquired the $1.2 million to purchase the
                              - 13 -

participation interest by virtue of the following circular

transaction with American:   (1) Petitioner borrowed $1.2 million

from American, and petitioner signed the Grojean note; (2)

petitioner returned the $1.2 million to American; (3) American

gave petitioner a participation certificate evidencing a $1.2

million participation interest in the Schanno note.    No cash

changed hands, and American handled the transaction through

simultaneous electronic debits and credits.    When the parties

amended the arrangement to include a participation interest in

the credit note, it was handled similarly with no cash changing

hands.

     The Schanno note and the credit note were the mirror images

of the Grojean note and the Grojean credit note, respectively.

When American received a monthly payment on the Schanno note or

the credit note, American credited petitioner’s participating

share to petitioner’s checking account and contemporaneously

debited the account for the interest payments due under the

Grojean note and the Grojean credit note.     Once American

recovered its principal on both notes, petitioner’s share of

principal was to be credited against the principal due on the

Grojean note and the Grojean credit note.   Payments by Schanno on

the Schanno note and the credit note kept petitioner current on

the Grojean note and the Grojean credit note.    Like a guarantor,

petitioner would not be liable--thus not called upon to make an
                                - 14 -

economic outlay--unless Schanno defaulted.     This conclusion is

consistent with the treatment of the participations in Schanno’s

certified financial statements.    Those statements, which were

certified as correct by the independent accounting firm and which

were reviewed by petitioner, disclosed the participations as a

guaranty by petitioner of the debt between American and Schanno.

     In Underwood v. Commissioner, supra, we held that the

taxpayer’s series of interrelated transactions was tantamount to

a disguised guaranty of an S corporation’s indebtedness to a

third party.    In that case, the taxpayers were the sole

shareholders of two corporations engaged in the retail barbecue

business, one a profitable C corporation (C-corp), the other an

unprofitable S corporation (S-corp).     The C-corp made loans to

the S-corp over nearly a 2-year period.     The S-corp gave the C-

corp promissory notes for the loans.     In an attempt to acquire

additional S-corp basis, the taxpayers rearranged the notes in

three steps:    (1) The C-corp surrendered the notes of the S-corp;

(2) one of the taxpayers gave a personal note to the C-corp; and

(3) the S-corp gave its note to that taxpayer.     We held that the

taxpayer did not make the requisite economic outlay and that the

substance of the arrangement was similar to a guaranty of the

indebtedness.    See Underwood v. Commissioner, supra at 475; see

also Estate of Leavitt v. Commissioner, 90 T.C. 206 (1988), affd.

875 F.2d 420 (4th Cir. 1989).    Likewise here, we find the
                               - 15 -

substance of the transactions to be a shareholder’s guaranty of

the indebtedness of an S corporation.

     Petitioner argues that there was bona fide indebtedness

between himself and American, and that his relending of the funds

to Schanno by way of purchasing a participation interest entitles

him to adjusted basis.   Petitioner relies on Raynor v.

Commissioner, 50 T.C. 762 (1968), for the proposition that when a

shareholder borrows funds from a third party and lends those

funds to his or her S corporation, he is entitled to basis.

Petitioner’s reliance is misplaced, and the fact that there was

bona fide indebtedness between American and petitioner is not

significant because petitioner did not relend the funds directly

to Schanno.    The statutory language makes clear the shareholder

will get basis only in “indebtedness of the S corporation to the

shareholder”.    Sec. 1366(d)(1)(B) (emphasis added).   This

requires a direct obligation between the shareholder and the S

corporation.    See Hitchins v. Commissioner, supra.    Such is not

the case here.

     The participation agreement makes clear that petitioner did

not become a lender to or creditor of Schanno.    There was no note

or other contract between petitioner and Schanno, and petitioner

was not a party to the Schanno note or the credit note.     American

had sole discretion to enforce all rights under the notes,

without the advice or consent of petitioner.    Petitioner’s
                              - 16 -

contractual relationship was with American.    Petitioner advanced

the funds to American which, in turn, advanced the funds to

Schanno.   If Schanno failed to pay, petitioner had no direct

contractual rights against Schanno.    There was no “direct

obligation” from Schanno to petitioner.    See Hitchins v.

Commissioner, supra.   Whatever rights petitioner had against

Schanno, if any, were derivative through American, and such

derivative rights are insufficient to give petitioner basis.

See id.

     We also do not find helpful to petitioner’s cause the

testimony of petitioner’s expert witness, Steven L. Harris.     We

recognized Harris as an expert on bankruptcy and creditor’s

rights, and petitioner proffered his testimony to establish that

petitioner had economic and business reasons for structuring the

transaction as a participation as opposed to a direct loan.

Harris opined that petitioner would enjoy a greater status as a

participant in the event Schanno went bankrupt.    Harris’

testimony, however, fully supports our conclusion that there was

no direct obligation between petitioner and Schanno for basis

purposes, as he testified on cross-examination as to what

petitioner’s rights would be if Schanno filed bankruptcy:

     Q: The lead bank would be the holder of the claim?
     A: The lead bank typically would be the holder of the
     claim in the bankruptcy.
     Q: And so if a proof of claim was filed, it would be
     under the lead bank’s name, not the participant’s name.
                                - 17 -

     Right?
     A: Yes.
     Q: Okay. And--I didn’t mean to interrupt. Go ahead.
     A: Yes. In addition, it is the lead bank who is
     enforcing the obligation in a participation agreement--
     Q: And is that because the participant has no rights
     to enforce that obligation?
     A: Yes.

     Petitioner’s reliance on Gilday v. Commissioner, T.C. Memo.

1982-242, is also misplaced.    In Gilday, the bank held the note

of an S corporation.   The taxpayer and other shareholders of the

S corporation issued their note to the bank, and the bank

canceled the S corporation’s note.       In exchange, the S

corporation gave its note, in the same amount, to the

shareholders.   The result was that the shareholders became the

sole obligors to the bank, and the S corporation was directly

indebted to the shareholders.    We held the shareholders had a

basis in the debt for purposes of former section 1374(c), the

predecessor of section 1366(d).3   That was not the case here.

Schanno was not directly indebted to petitioner in any way, and

petitioner’s rights were against American, not Schanno.       Because

the notes from the corporation to the bank were the mirror image


     3
      We recognize that in Gilday v. Commissioner, T.C. Memo.
1982-242, the shareholders of the S corporation did not make
an actual outlay of funds. However, our holding in Gilday is
that the substitution of the shareholders as the sole
unconditional obligors to the bank and of the S corporation as
the sole unconditional debtor to the shareholders constituted a
constructive furnishing by the shareholders of the funds
previously loaned by the third party bank. See also Hitchins v.
Commissioner, 103 T.C. 711 (1994).
                              - 18 -

of his notes to the bank, there was complete circularity of

funds, and his status was in substance not that of the

corporation’s creditor but of guarantor of the corporation’s debt

to the bank.

We hold petitioner is not entitled to basis under section 1366(d)

for his participation interests in the Schanno note and the

credit note totaling $1.2 million.

     We turn to the additions to tax for failure to file timely.

Section 6651(a)(1) reads in pertinent part:

     In case of failure * * * to file any return * * * on
     the date prescribed therefor * * *, unless it is shown
     that such failure is due to reasonable cause and not
     due to willful neglect, there shall be added to the
     amount required to be shown as tax on such return 5
     percent of the amount of such tax if the failure is for
     not more than 1 month, with an additional 5 percent for
     each additional month or fraction thereof during which
     such failure continues, not exceeding 25 percent in the
     aggregate.

     To escape the addition to tax for filing the 1989 and 1990

returns untimely, petitioners must prove that (1) their failure

to file timely did not result from willful neglect, and (2) this

failure was due to reasonable cause.   On brief, respondent

proposed the following finding of fact:   “Petitioners failed to

file timely income tax returns for 1989 and 1990, and their

failure was due to willful neglect and not due to reasonable

cause.”   Petitioners did not object to this proposed finding of

fact, nor did they proffer any evidence that would suggest that

reasonable cause existed.   We hold petitioners are liable for the

additions to tax under section 6651(a)(1) as determined by
                             - 19 -

respondent.

     We have considered all arguments made by petitioners for

holdings contrary to those herein, and, to the extent not

addressed above, find them to be irrelevant or without merit.

Due to concessions of the parties,



                                          Decision will be entered

                                     under Rule 155.
