Estate of Yamamoto v. C.I.R., 102390 FEDTAX, 13280-85

Docket Nº:13280-85.
Opinion Judge:CHABOT, JUDGE:
Attorney:Hirotoshi Yamamoto, pro se. Henry E. O'Neill, for the respondent.
Case Date:October 23, 1990
Court:United States Tax Court

60 T.C.M. (CCH) 1050




No. 13280-85.

United States Tax Court

October 23, 1990

Petitioner husband (H) was sole owner of the voting stock of MFC, an industrial loan company in Hawaii. Hawaii requires industrial loan companies to maintain a debt-to-capital ratio of ten-to-one. In years before the years in issue, H borrowed money and used the loan proceeds to buy more stock in MFC. In Yamamoto v. Commissioner, T.C. Memo. 1986-316, affd. without published opinion 891 F.2d 297 (CA9 1989), we held that deduction of H's interest payments on those loans was limited by the investment interest rules. H incorporated MEI, a holding company, on June 20, 1977. On June 28, 1977, in return for all of MEI's stock and a promissory note in the amount of $1,774,066, H transferred all of his MFC common stock to MEI. In June and August of 1981, H consolidated certain of his debts to MFC into three promissory notes totalling $1,646,795. On October 15, 1981, he assigned the $1,774,066 note from MEI to MFC in satisfaction of his debts.

HELD: (1) Certain of H's interest expenses are subject to the investment interest deduction limitations under section 163(d), I.R.C. 1954. Burden of proof. However, respondent's assertion of collateral estoppel is rejected.

HELD: (2) Petitioners realized income from the discharge of indebtedness when H used the $1,774,066 note to satisfy his debts to MFC, because the note was worthless. Sec. 61(a)(12), I.R.C. 1954.

H guaranteed certain debts of one of his corporations to MFC. As part of the corporation's liquidation, H issued a note to MFC. (This was one of the debts consolidated in mid-1981; the note was discharged on October 15, 1981, in exchange for the MEI note.)

HELD: (3) Petitioners are not entitled to a bad debt deduction on account of H's guarantee, because H never paid on his guarantee. Secs. 166(a) and (b), I.R.C. 1954.

H was a 50-percent owner of a partnership (P). P, on the cash basis, accrued interest on a debt it owed; P did not pay the interest. P lent money to others; the debts became worthless during 1981. P had interest expense.

HELD: (4) Petitioners are not entitled to deduct that portion of P's claimed loss attributable to the accrued but unpaid interest.

(5) Petitioners are entitled to deduct that portion of P's claimed loss attributable to the bad debt, but only as a nonbusiness bad debt. Sec. 166(d), I.R.C. 1954. Burden of proof.

(6) Petitioners must treat as investment interest that portion of P's claimed loss attributable to P's interest expense. Burden of proof.

Hirotoshi Yamamoto, pro se.

Henry E. O'Neill, for the respondent.



Respondent determined deficiencies in Federal individual income tax against petitioners for 1980 and 1981 in the amounts of $103,933 and $1,153,327, respectively.

After a concession by respondent [1], the issues for decision are as follows. [2]

(1) Whether certain interest expenses of petitioners for 1981 are subject to the section 163(d) limitations on investment interest deduction.

(2) Whether petitioners realized income from the discharge of indebtedness in 1981.

(3) Whether petitioners are entitled to a bad debt deduction for 1980.

(4) Whether petitioners are entitled to a partnership loss deduction for 1981, the components of the loss being (a) the partnership's accrued but unpaid interest, (b) the partnership's bad debts, and (c) the partnership's asserted investment interest.


Some of the facts have been stipulated; the stipulation and the stipulated exhibits are incorporated herein by this reference.

When the petition was filed in the instant case, petitioners Hirotoshi Yamamoto (hereinafter sometimes referred to as ‘ Yamamoto‘ ) and Shizuko Yamamoto, husband and wife, resided at Waianae, Hawaii. Petitioners were cash basis taxpayers for both years in issue.

Yamamoto is an insurance agent and salesman. Yamamoto also was licensed as a general building contractor from July 1, 1958, until May 1, 1986, when his license was placed on inactive status.


In 1960, Yamamoto and two others incorporated Manoa Finance Company (hereinafter sometimes referred to as ‘ MFC‘ ) under Hawaii law as an industrial loan company. Until 1977, Yamamoto owned all the common stock of MFC.

Industrial loan companies in Hawaii make loans and issue interest-bearing thrift certificates to savers. Hawaii closely regulates industrial loan companies, and prohibits them from having outstanding at any time debentures or loan certificates in excess of ten times the amount of paid-up capital and surplus. Hawaii Rev. Stat. sec. 408-14(c). [4]

On June 20, 1977, Yamamoto incorporated Manoa Enterprises, Inc. (hereinafter sometimes referred to as ‘ MEI‘ ), a holding company, under Hawaii law. When Yamamoto incorporated MEI, he was the sole shareholder of the voting, common stock of MFC. His basis in MFC common stock as of that date was $2,772,066. By letter agreement dated, accepted, and effective June 28, 1977, Yamamoto transferred all of his MFC common stock to MEI. In return, Yamamoto received all of the stock of MEI (99,800 shares) with an assigned value of $998,000. At the same time, Yamamoto paid $2,000 to MEI and MEI gave to Yamamoto an unsecured promissory note (hereinafter sometimes referred to as ‘ the MEI note ‘ ) in the face amount of $1,774,066. The MEI note bore an interest rate of 6 percent and provided for no payment of principal or interest until the expiration of the 10-year term (on June 28, 1987), at which time the principal and accumulated interest were due in full.


In earlier years (i.e., before 1980), Yamamoto had borrowed money and used the proceeds of the loans to buy more stock in MFC. [5] Yamamoto bought the stock to help MFC meet Hawaii's debt-to- capital requirements for industrial loan companies. On their income tax returns, petitioners deducted $105,810.56 for 1980, and $73,943.81 for 1981 as interest paid on business indebtedness as part of Yamamoto's Schedule C contracting business. In the notice of deficiency, respondent determined that for 1980, petitioners were entitled to an additional deduction of $13,234. [6] For 1981, respondent determined that petitioners were entitled to $14,054 less than they claimed. [7]


In 1981, Yamamoto executed three promissory notes in favor of MFC, representing a consolidation of amounts that he owed to MFC, more fully described below. The total amount of the three notes was $1,646,794.52.

The three components of Yamamoto's debt to MFC of $1,646,794.52 are as shown in table 1.

Table 1
a. the $408,811.29 note
b. the 218,490.39 note-Makaha Reef
c. the 1,019,492.84 liability-T-Y Partnership
a. THE $408,811.29 NOTE Yamamoto executed a promissory note to MFC in the principal amount of $408,811.29, dated August 7, 1981 (hereinafter sometimes referred to as ‘ the $408,811.29 note‘ ). The $408,811.29 note was nonrecourse, bore a simple interest rate of 6 percent, was due on June 28, 1987, and did not provide for payments of principal or interest until that date, at which time the principal and accumulated interest were due in full. (See n.3, supra.) The principal sum of the $408,811.29 note was made up of various notes by third parties who had executed promissory notes to MFC on various dates, which notes were assumed by Yamamoto on July 2, 1981. Six of these assumed notes, with remaining balances aggregating $259,500, bore interest at 10 percent. The money that had been borrowed from MFC in connection with these notes had been transferred by the borrowers to Yamamoto. Another $97,911.29 resulted from a sale of property by Yamamoto. Through a series of transactions, MFC acquired Yamamoto's rights in the sale transaction. The buyer paid off his remaining obligations to an escrow service, which applied the funds to pay off mortgages on real property owned by Yamamoto. This application of the escrowed funds for Yamamoto's benefit gave rise to Yamamoto's debt to MFC. The remaining $51,400 arose from MFC's payment of Yamamoto's liability in that amount to Great Hawaiian Realty. b. MAKAHA REEF TRANSACTION Yamamoto and Sakai Takahashi (hereinafter sometimes referred to as ‘ Takahashi ‘ ) were each 50-percent shareholders in Makaha Reef, Incorporated (hereinafter sometimes referred to as ‘ Makaha Reef‘ ). Makaha Reef was incorporated in 1965 and listed its principal business activity as a developer of real estate. The corporation was the owner of unimproved development real properties in Makaha, Hawaii. On June 30, 1981, when MFC was foreclosing on Makaha Reef, Yamamoto and Takahashi transferred Makaha Reef's assets to MFC. On that date, Makaha Reef's adjusted basis in these assets was $2,054,478.03. Its liabilities amounted to $2,491,458.80, of which $1,467,918.83 was due to MFC. Makaha Reef's paid-in capital totaled $5,000, of which Yamamoto provided $2,800. After the transfer, Yamamoto and Takahashi, as guarantors of Makaha Reef's notes to MFC, still owed $436,980.77 to MFC (liabilities of $2,491,458.80, less assets basis of $2,054,478.03). Yamamoto executed a promissory note dated June 30, 1981, to MFC for $218,490.39 (hereinafter sometimes referred to as ‘ the $218,490.39 note ‘ ), which represented his 50- percent share of the balance he and Takahashi owed to MFC after the transfer. [8] On the same day, MFC cancelled Makaha Reef's indebtedness to MFC, and assumed Makaha Reef's other liabilities in the amount of $1,023,539.97. In 1981, Makaha Reef was dissolved. On October 15, 1981, the $218,490.39 note was treated as ‘ paid‘ through a series of assignments and adjustments, explained in greater detail below. No new funds were paid in to MFC. Petitioners'...

To continue reading