                         T.C. Memo. 2001-271



                       UNITED STATES TAX COURT



                CERAND & COMPANY, INC., Petitioner v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent*



     Docket No. 2767-97.             Filed October 9, 2001.



     Gerard A. Cerand (an officer), for petitioner.

     Gregory S. Matson and Warren P. Simonsen, for respondent.



         SUPPLEMENTAL MEMORANDUM FINDINGS OF FACT AND OPINION



     GERBER, Judge:    This case was remanded for further

proceedings by the Court of Appeals for the District of Columbia

Circuit.    Cerand & Co. v. Commissioner, 254 F.3d 258 (D.C. Cir.



     *
       This opinion supplements a previously released opinion,
Cerand & Co. v. Commissioner, T.C. Memo. 1998-423.
                               - 2 -

2001) (Cerand II).   In T.C. Memo. 1998-423 (Cerand I), we held

that the advances petitioner made to sister

corporations were equity and not debt as claimed by petitioner.

In Cerand II, the Court of Appeals held:

          In the present case, we hold that the [Tax Court]
     abused its discretion in assessing the evidence. The
     critical flaw in the [Tax Court’s] analysis is its
     failure, despite the taxpayer having pressed the point,
     to consider * * * [petitioner’s] contemporaneous
     treatment of sums received from its sister corporations
     as in part the payment of “interest,” taxable as income
     to * * * [petitioner]. Over a period of several years,
     * * * [petitioner] received $414,220 from the three
     [sister] corporations, of which it booked more than
     $175,000 as interest income. Even though * * *
     [petitioner] had taxable income in only two of the
     years in question (1986 and 1987), treatment of the
     repayments as income in other years reduced the amount
     of net operating loss * * * [petitioner] could carry
     forward into years when it had taxable income.

          Although the [Tax Court] abused its discretion by
     omitting from its analysis a highly significant bit of
     evidence, we cannot say that, had the [Court] properly
     weighed this evidence, it necessarily would have
     reached a different conclusion, because we do not know
     what weight it assigned to the other evidence.
     Therefore, we remand this case for the [Tax Court] to
     weigh all the evidence in the first instance.

          We also note that the [Tax Court] placed
     considerable weight upon the lack of documentation
     indicating that the transfers of funds from * * *
     [petitioner] to its sister corporations were loans.
     Because there were no documents recording the transfers
     there necessarily were no stated maturity dates, no
     repayment schedules, and no set interest rates. As the
     Seventh Circuit recently observed in similar
     circumstances, “it is hazardous to say * * * that an
     investment must be equity because it is not documented
     as debt; lack of documentation does not help us
     choose.” J & W Fence Supply Co. v. United States, 230
     F.3d 896, 898 (2000). * * * [Petitioner] does not raise
                               - 3 -

     this argument, however, and we therefore do not
     consider it.

     Based on the above-quoted holding, we understand the Court

of Appeals’ remand to require this Court to provide further

explanation of our holding, with emphasis on the weight given to

petitioner’s treatment of repayments and interest accruals.

                         FINDINGS OF FACT

Findings in Earlier Opinion

     In Cerand I, we found the following facts concerning the

interest accruals and repayments by petitioner’s three sister

corporations:

     From time to time, the three corporations made cash
     repayments, or book entry credit was made to the
     advances for services rendered to petitioner. While
     the corporations were viable, they repaid $414,220 to
     petitioner. Petitioner accrued interest only
     sporadically on the advances to two of the corporations
     and failed to accrue any interest against the advances
     to the third, contrary to the advice of Mr. Cerand’s
     tax adviser. The interest that petitioner did accrue
     on its books was rolled over annually into a note
     receivable and reported as income by petitioner.
     Because that income was never actually received by
     petitioner, respondent has allowed a deduction against
     ordinary income for that amount.

Additional Findings in Record That Support the Above-Quoted
Findings

     Petitioner began advancing funds to its three sister

corporations in 1984 and over an 8-year period advanced

$1,413,374.17.   One of the sister corporations had advances

outstanding for 8 years, and the other two each had advances
                               - 4 -

outstanding for 7 years.   Accordingly, among the three sister

corporations, advances were outstanding to petitioner for a total

of 22 annual accounting periods.    Petitioner accrued and reported

interest income with respect to 8 of the 22 accounting periods.

No interest was accrued or reported with respect to 14 of the 22

annual accounting periods.   The total amount of interest accrued

and reported by petitioner for the period 1984 through 1991 was

$175,662.   No amount of the accrued and reported interest was

paid by the sister corporations.    Instead, it was rolled over

into a note receivable each year.

     The reported interest was sporadic in amount and also varied

as a percentage of the outstanding amount of advances.    Treating

the cumulative advances1 outstanding annually for each sister

corporation as the denominator and the amount of reported

interest as the numerator,2 the following percentage rate of

interest would result:




     1
       The outstanding annual cumulative advances used take into
account increases for advances and reductions for any payments or
credits during the year.
     2
       No interest income was accrued or reported by petitioner
with respect to one of the three sister corporations--Cerand
Aviation
                                 - 5 -

                             Cumulative     Interest
Sister Corp.     Year         Advances      Reported   Percent

First World      1984          $10,260        $1,160    11.3
First World      1985          111,129         7,194     6.5
First World      1986          271,094        13,965     5.2
First World      1987          496,153        31,288     6.3
First World      1988          654,077        51,349     7.8
First World      1989          808,333        65,206     8.1
Airport Ser.     1987           48,866         2,416     4.9
Airport Ser.     1988           65,650         3,084     4.7

     Throughout the 8-year period the amount of outstanding

advances was increasing, the amount of repayment was decreasing,

and no amount of interest was paid by the sister corporations.

Instead of being paid, any interest accrued by petitioner was

merely rolled over annually into a note receivable.     As the

sister corporations’ revenues decreased, advances from petitioner

generally increased, reflecting a lack of concern about the

possibility of repayment.     Petitioner continued to advance funds

to its three sister corporations even though conditions worsened,

and the likelihood of repayment diminished.     The three sister

corporations did not seek financing from outside sources.

     The three sister corporations made a total of $414,220 in

repayments, which petitioner applied to the outstanding open

“account receivable”.     The repayment amounts were sporadic, and

they were not uniform in amount.     For example, during 1986

petitioner advanced $151,000 to First World Corp. and $5,000 was

repaid.   In the next year (1987), $184,600 was advanced, and

nothing was repaid.     During the following year (1988) $163,025
                                - 6 -

was advanced and $57,650 was repaid.     The three sister

corporations failed to file corporate Federal income tax returns

for the years under consideration.

                               OPINION

     To decide whether advances constitute debt or equity, we are

to make a factual inquiry into whether a taxpayer has shown a

bona fide debtor-creditor relationship.     Calumet Indus., Inc. v.

Commissioner, 95 T.C. 257 (1990); Segel v. Commissioner, 89 T.C.

816, 827 (1987).    Although bona fide debt may exist between

related parties, such transactions between related parties are to

be subjected to particular scrutiny.     In re Uneco, Inc., 532 F.2d

1204, 1207 (8th Cir. 1976).    The determination of whether

advances to a corporation have created bona fide indebtedness

depends on whether there is an intention to create an

unconditional obligation to repay the advances.     See Raymond v.

United States, 511 F.2d 185, 190 (6th Cir. 1975).

      In Cerand I, we identified 13 factors used by courts to

assist them in deciding whether particular advances constituted

debt or equity.    We noted that the factors are not equally

significant and that no factor is determinative or relevant in

each case.    John Kelly Co. v. Commissioner, 326 U.S. 521, 530

(1946); Estate of Mixon v. United States, 464 F.2d 394, 402 (5th

Cir. 1972).   Finally, we recognized that the factors used are

only aids in our analysis of whether the advances (1) constitute
                               - 7 -

risk capital entirely subject to the fortunes of the corporate

venture or (2) represent a debtor-creditor relationship that

comports with economic reality.   Fin Hay Realty Co. v. United

States, 398 F.2d 694, 697 (3d Cir. 1968); Litton Bus. Sys., Inc.

v. Commissioner, 61 T.C. 367, 377 (1973).

     In Cerand I we identified the relevant facts and then

analyzed them in three generalized categories, each of which

included several of the 13 factors.    In compliance with the Court

of Appeals’ mandate, we express in greater detail the factors

considered in reaching our decision that the advances were equity

rather than debt.

     The record generally reflects that petitioner’s advances

created equity in its sister corporations.   Although not a

decisive factor, no certificates evidencing indebtedness were

prepared or executed by or between petitioner and its three

sister corporations to which the advances were made.   Also, the

owner, Gerald A. Cerand, was not issued shares of stock in the

three newly created corporations to which the advances were made.

     With regard to petitioner’s expectation of interest and

payments, there was no fixed date or schedule for repayment of

the advances.   Petitioner could look only to revenues/profits of

the three sister corporations for repayment of the advances

and/or the payment of interest.   Although petitioner contends

that it had a right to enforce payment from its sister
                               - 8 -

corporations, petitioner’s only effort to enforce collection

occurred after it was clear that the sister corporations had

failed and were to become defunct, whereupon petitioner recovered

the only remaining asset-–the cash value of a life insurance

policy on Mr. Cerand.

     Control of petitioner and its three sister corporations

rested with Mr. Cerand.   He was the sole shareholder of

petitioner, the alleged creditor, and he was also the sole

shareholder of all three sister corporations, the alleged

debtors.   Mr. Cerand in conjunction with petitioner as the equity

investor in its sister corporations, not only participated in the

management, but controlled all aspects of all four corporations.

     Although petitioner contended it was the intent of the

parties to create debt, the alleged debt would have been

subordinate to any creditors the three sister corporations may

have had, because petitioner did not take the usual or ordinary

precautions to ensure its position vis-a-vis unrelated creditors.

     Essentially, petitioner bankrolled a group of startup

corporations.   If we accepted petitioner’s characterization that

all advances were loans, then the startup equity or capital was

less than thin--it was nonexistent.    This may explain why

petitioner and its related entities did not try to obtain credit

from outside sources.   Petitioner’s advances were used, initially

as startup capital and later for the operation and overhead of
                               - 9 -

the three entities’ businesses.   Moreover, the advances made by

petitioner were completely dependent upon the success of startup

companies, none of which had prior business history, security,

assets, or other guaranties of repayment.   And finally,

petitioner’s sister corporations repaid only a small percentage

of the advances.

      As we noted in Cerand I, some of the factors usually

considered by lenders such as capitalization, risk, the

availability of financing from outside sources, and the use to

which advances are put can help to identify whether the

transaction was within the realm of economic reality.   “[T]he

touchstone of economic reality is whether an outside lender would

have made the payments in the same form and on the same terms.”

Segel v. Commissioner, 89 T.C. 816, 828 (1987).   Here, petitioner

accrued and reported a relatively small percentage of the

interest that would have accrued if the advances were truly debt.

No interest was paid to petitioner by the sister corporations.

Instead, the accruals were rolled over annually into a note

receivable.   Even if the $175,662 of interest reported by

petitioner had been paid to it by the sister corporations, the

amount of interest that was accrued and reported does not comport

with economic reality in the context of a creditor-debtor

relationship.
                              - 10 -

     During the 8-year period under consideration, petitioner’s

advances to the three sister corporations totaled $1,413,374.17.

During that same period, the three sister corporations repaid

$414,220.   Accordingly, approximately 29 percent of the total

amount advanced by petitioner was repaid by the sister

corporations.   The repayments were sporadic, not uniform in

amount, and depended upon the ability of the sister corporations

to pay.   For example, in 1986 petitioner advanced $151,000 to

First World Corp., and $5,000 was repaid.    In the next year

(1987) $184,600 was advanced, and nothing was repaid.    In the

following year (1988) $163,025 was advanced, and $57,650 was

repaid.   Petitioner continued to advance funds to the sister

corporations in generally increasing amounts even though the

relative amount of repayment and ability to repay were steadily

decreasing.

     Petitioner did accrue and report $175,662 as interest income

over the 9-year period, 1984 through 1992.    Interest income,

however, was accrued and reported only for one sister corporation

for its 1984 through 1989 years and for another for its 1987 and

1988 years.   Accordingly, petitioner accrued and reported

interest income in only 8 of 22 annual accounting periods of the

sister corporations--approximately one-third of the time.

     When interest was accrued and reported, it was not uniform

in amount or percentage.   As calculated previously, the rate or
                              - 11 -

percentage of the interest accrued and reported, based on the

cumulative outstanding yearend balances, ranged from a low of 4.7

percent to a high of 11.3 percent.     Using a weighted average for

the eight accruals of interest, the average rate of interest

accrued would have been 7.3 percent.     If interest at 7.3 percent

had been accrued and reported on all of the outstanding

cumulative balances of the sister corporations, petitioner would

have reported approximately $400,000.3

     If a creditor would have charged 7.3 percent interest during

the period under consideration, then petitioner by reporting

$175,622 in interest reported approximately 44 percent of the

interest that should have been accrued.4    The apparent rate of

interest accrued by petitioner, however, appears to be far below

the going rate.   During the early 1980s, the prime rate was in a

precipitous climb and would eventually exceed 20 percent before

the end of the decade.   See, e.g., Finkelman v. Commissioner,



     3
       These amounts were calculated from Exhibit 21-U by adding
the outstanding balances for 22 accounting periods--eight for
First World Corp. and 7 each for Cerand Aviation Inc. and Airport
Services Corp. and then applying simple interest at 7.3 percent.
It should be noted that with respect to Airport Services Corp.,
no advances were made after its 1988 year, but it did not become
defunct until sometime in 1990. Accordingly, its $65,650
cumulative balance was considered outstanding for 1989 and 1990.
     4
       Because petitioner accrued interest only in 8 of 22
accounting periods, the interest being accrued is essentially on
a simple interest basis; i.e., interest was not accrued or added
to the cumulative balances for 14 of 22 accounting periods.
                              - 12 -

T.C. Memo. 1989-72.   It was not unusual for interest rates during

the period under consideration to be in the 20 to 24 percent

range.   See, e.g., Goldstein v. Commissioner, 89 T.C. 535, 548

(1987); Bruce v. Martin, 845 F. Supp. 146 (S.D.N.Y 1994); In re

Presque Isle Apartments, L.P., 118 Bankr. 332 (Bankr. W.D. Pa.

1990).   A third-party creditor would not have advanced funds to

the sister corporations at a preferred rate (less than 10

percent), considering the fact that they were startup companies

without a business performance record, assets, security,

guaranties, etc.   If we assume a 10-percent rate, the total

interest accruable would have been almost $550,000.   At 15

percent, the interest accruable would have approached $825,000.5

If we assumed a 10-percent annual rate of compound interest, the

accrual for the cumulative advances for all 22 accounting periods

would have been an amount approaching $600,000.   Accordingly, in

perspective, petitioner accrued and/or reported only a small

percentage of the amount of interest that would have been due to

an unrelated creditor during the years under consideration.

     Petitioner’s accountant/tax adviser recommended that

interest be accrued and reported for all years.   We do not know

why petitioner did not take that advice.   Petitioner has not

provided any explanation as to why it failed to accrue or report


     5
       All of the above calculations are, for the most part,
based on simple interest. The cumulative balances on Exhibit 21-
U have been increased for accrued interest in only 8 of 22
possible annual periods.
                                - 13 -

interest in 14 of 22 possible instances.       Further, petitioner has

not provided any explanation as to why interest was not accrued

at a fixed rate or why the rate purportedly6 charged appears to

be below market.

     The only factors in this case that are helpful to petitioner

and/or supportive of its argument are the partial repayments and

the accrual of interest.   Repayment of principal and accrual or

payment of interest can be significant indicators of whether

advances are loans or equity.    Generally, shareholders place

their money at the risk of the business while lenders seek a more

reliable return.   See Midland Distribs., Inc. v. United States,

481 F.2d 730, 733 (5th Cir. 1973).       In the overall setting of

this case, however, the repayments and interest accruals are

insufficient to overcome the weight of the evidence reflecting

that, in form and substance, neither petitioner nor its sister

corporations intended the advances to be loans, nor did they

treat them as loans.

     Petitioner, Mr. Cerand, and the three sister corporations

did not have a creditor-debtor relationship.       The repayments were


     6
       There has been no showing that interest was paid and/or
that there was any fixed or legal obligation for the sister
corporations to pay interest. Likewise, the sister corporations
did not file returns, and no records were offered showing how
they treated the repayments and/or whether they made charges
against their revenues for interest expense.
                                - 14 -

merely book entries.   As soon as some amount was repaid to

petitioner (always substantially less than had been advanced)

petitioner would make another, usually larger advance to the

sister corporations.   Significantly, we note that while the

repayments were decreasing and the sister corporations’ ability

to repay was dwindling, petitioner continued to advance funds in

progressively larger amounts.

     It is important to note that no interest was actually paid

to petitioner by the sister corporations.    In a similar manner to

the repayments, the interest accruals appear to be an attempt to

simulate the existence of debt.    We note that the accruals were

limited, sporadic, and had no apparent fixed percentage.

     As noted by the Court of Appeals for the D. C. Circuit,

petitioner reported taxable income only in 2 of the years under

consideration, 1986 and 1987.    In five of the periods in which

interest was accrued by petitioner, the accrual of interest

merely reduced petitioner’s losses and did not result in taxable

income.   Put another way, of the $175,662 of interest accrued and

reported by petitioner, only $45,253 (about one-fourth) resulted

in additional tax burden on petitioner.

     When compared to the outstanding cumulative balance, the

amount of interest accrued was substantially less in percentage

than the going rate of interest during the period under

consideration.   Again, no interest was actually paid by the
                              - 15 -

sister corporations, and while their ability to repay principal

or to pay interest was decreasing, petitioner continued to

advance ever-increasing amounts.

     Petitioner’s actions and the facts in this record do not

portray the type of debtor-creditor relationship that petitioner

must show to qualify for ordinary loss treatment under section

166, I.R.C. 1986.   Considering the lack of intent evidenced by

the manner in which repayment was made and interest accrued and

the lack of objective evidence of debt, after reconsidering the

evidence, we reach the same conclusion as we reached in Cerand I-

- petitioner was an investor in the three sister corporations and

is not entitled to debt treatment under section 166.

     To reflect the foregoing,

                                      Decision will be entered

                                 for respondent.
