American Underwriters, Inc. v. Commissioner

• Decision Date: 18 December 1996
• Docket Number: Docket No. 14263-95.
• Citation: 72 T.C.M. 1511
• Parties: American Underwriters, Inc. v. Commissioner.
• Court: U.S. Tax Court

72 T.C.M. 1511

T.C. Memo. 1996-548

American Underwriters, Inc. v. Commissioner.

Docket No. 14263-95.

United States Tax Court.

Filed December 18, 1996.

Alfred Roven (an officer) and Joy Martin (specially recognized), San Anselmo, Calif., for the petitioner. Rebecca T. Hill and Bryce A. Kranzthor, for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge:

American Underwriters, Inc., petitioned the Court to redetermine respondent's determination with respect to its 1987 and 1988 taxable years. For petitioner's taxable year ended February 29, 1988, respondent determined a $1,012,554 deficiency and a $53,188 addition thereto under section 6653(a)(1)(A). Respondent also determined that the time-sensitive provision of section 6653(a)(1)(B) applied to the entire deficiency. For petitioner's taxable year ended February 28, 1989 (petitioner's 1988 taxable year), respondent determined a $261,672 deficiency and a $13,084 addition thereto under section 6653(a)(1).

Following concessions, we must decide:

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

2. Whether any of these advances were worthless as of February 29, 1988. We hold they were to the extent described herein.

3. Whether petitioner is liable for the additions to tax determined by respondent. We hold it is not.

Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the subject years. Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulated facts and exhibits submitted therewith are incorporated herein by this reference. Petitioner's principal place of business was in San Anselmo, California, when it petitioned the Court.

Petitioner was organized by Alfred Roven (Mr. Roven) on October 20, 1980, primarily to transact business in the securities market, buying and selling securities, bonds, and derivatives, among other things. Mr. Roven is petitioner's sole shareholder, as well as its president and one of its two directors. Joy Martin (Ms. Martin) is petitioner's other director, and she is its secretary and bookkeeper.

Mr. Roven organized Kenilworth Corp. (Kenilworth), on January 12, 1982, to trade securities and to provide consulting services on the trading of securities. Mr. Roven owns 40 percent of Kenilworth's stock, and its remaining stock is equally owned by two of his children. Kenilworth's taxable year ends on May 31, and it began filing a consolidated income tax return with a lone subsidiary effective with its taxable year ended May 31, 1988 (Kenilworth's 1987 taxable year).¹ Kenilworth had $1,000 of capital stock outstanding at the beginning and end of its 1987 taxable year.

During all years relevant herein, petitioner and Kenilworth invested primarily in Limited Price Options (LPO's) sold by Bear, Stearns & Co., Inc. (Bear Stearns), and Prudential Bache & Co. (Prudential Bache). An LPO is an extremely high risk, sophisticated financial instrument designed for aggressive hedge funds, risk arbitageurs, and professional traders. In general, a purchaser of an LPO pays 20 percent of the market value of a package of securities in return for the right to buy those securities at a set price during a set period of time. Once purchased, an LPO may be traded only with the brokerage firm from which it was purchased. An LPO is like a conventional option in that it creates leverage to enhance the purchaser's potential gain in a strong market. However, the premium paid for an LPO is generally lower than the premium paid for a comparable conventional option because the terms of the LPO provide that it will automatically expire without value whenever the market value of the related securities falls below a set dollar amount (Expiration Price). To minimize the risk of loss in a declining market, a purchaser of an LPO may execute an addendum to an LPO contract, under which the seller/brokerage firm will repurchase the LPO and issue a new one (for an additional cost) whenever the value of the related securities equals the Expiration Price.

Bear Stearns acquired the underlying securities for the LPO's that it sold to petitioner or Kenilworth. When Bear Stearns sold an LPO to petitioner or Kenilworth, Bear Stearns charged the purchaser a purchase commission that was based on the gross cost of the underlying securities. When the purchaser exercised or otherwise disposed of the LPO, Bear Stearns charged the purchaser a selling commission based on the gross proceeds of the securities. Prudential Bache followed a similar, overall procedure with respect to the LPO's that it sold to petitioner or Kenilworth.

Pursuant to the terms of the LPO's purchased by petitioner or Kenilworth, the Expiration Price was set at an amount that reflected a 3 percent decline in the value of the related securities. Under the terms of the addendums that petitioner or Kenilworth entered into with the seller/brokerage firm, the seller would: (1) Repurchase an LPO every time that the market value of the related securities equaled the Expiration Price and (2) simultaneously issue a new LPO for the same securities, the payment of which was due on the day of issuance. The repurchase price of an LPO equaled the amount by which the proceeds received from selling the underlying securities (usually the market price less commissions and other costs) exceeded the exercise price for that day. If the purchaser failed to transfer the requisite funds to the seller within the required period of time, the LPO would cancel and the seller would retain all of the funds that the purchaser had previously paid to purchase it.

Mr. Roven directed the trading activities of petitioner, Kenilworth, and certain other related entities that are not directly relevant to our decision herein. Mr. Roven caused petitioner (or, sometimes, one of the other related entities) to buy the positions in his recommended securities (including LPO's), and he divided the interests in these positions among the entities in a preset manner. All purchases of LPO's with the funds of petitioner were contemporaneously recorded as "loans" to Kenilworth and the other related entities to the extent that each entity (including Kenilworth) benefited therefrom. None of these "loans" (hereinafter referred to as advances) were evidenced by a written agreement (e.g., a note) because Mr. Roven did not believe that he needed to prepare one, given the fact that he controlled all of the entities and they were commonly owned. For the same reason, none of the advances were directly secured, and none of the entities paid interest on any of the advances.

Petitioner and Kenilworth considered the advances to be debt that was payable on demand without a set maturity date, and they intended at the time of each advance that it would be repaid shortly after it was made. Prior to October 19, 1987, Kenilworth regularly repaid each advance shortly after it received the advance. On October 19, 1987, the Dow Jones industrial average fell 22.6 percent (hereinafter, this fall is referred to as the Crash), which was the worst decline since World War I and greater from a numerical standpoint than the 12.82 percent drop on October 28, 1929. Some stocks dropped 50 percent on that day, and petitioner and Kenilworth's 3 percent trigger for repurchase of the LPO's was hit 15 times, resulting in extraordinary losses to them. Kenilworth lost at least $23.6 million on the day of the Crash, mainly with respect to its LPO's.

Before the Crash, petitioner and Kenilworth had entered into cross-collateral and guarantee agreements with Bear Stearns and Prudential Bache under which: (1) Every LPO owned by petitioner was collateralized by an LPO owned by Kenilworth, and vice versa, and (2) petitioner was liable for any charges incurred by Kenilworth on its purchase of an LPO, and vice versa. Mr. Roven approved all of these agreements. Petitioner and Kenilworth were both financially healthy and profitable when they signed these agreements, and they entered into these agreements with a proper and valid business purpose, both providing consideration for the agreements and receiving value therefrom. Petitioner's primary business purpose was to increase its profits and net worth, and petitioner realized this purpose until the Crash. The Crash caused the leverage which had allowed petitioner and Kenilworth to grow extraordinarily during 1986 and 1987 to backfire and generate extraordinary losses to the two entities.

In addition to the advances mentioned above, petitioner transferred money to Kenilworth or to other parties (e.g., Bear Stearns and Prudential Bache) on Kenilworth's behalf. Petitioner treated these transfers similarly to the advances above. These transfers were contemporaneously recorded in petitioner's books as "loans", and petitioner intended at the time of each transfer that the transfers would be repaid by Kenilworth. Both petitioner and Kenilworth treated these transfers as demand loans, and Kenilworth regularly repaid all of these transfers within 90 days of the transfer. Prior to the Crash, petitioner received timely repayment of all of its debts that were due from Kenilworth. (Hereinafter, we collectively refer to the transfers and advances as advances.)

Kenilworth owed petitioner over $18 million in advances as of the last day of Kenilworth's 1987 taxable year. Petitioner had advanced Kenilworth approximately $15 million of this sum to support the cross-collateral and guarantee agreements. Petitioner's board of directors (Board), following its evaluation of the receivable from Kenilworth in consultation with advisers (including petitioner's independent accountant (C.P.A.), a certified public accountant who was extremely familiar with the business and operation of petitioner, of Kenilworth, and of the other related entities), unanimously agreed at a duly held board meeting to forgive $5 million of the...