McAlister v. Commissioner
| Decision Date | 26 February 1976 |
| Docket Number | Docket No. 7657-73. |
| Citation | 1976 TC Memo 51,35 TCM (CCH) 232 |
| Parties | Andrew J. McAlister, Jr. and Alberta L. McAlister v. Commissioner. |
| Court | U.S. Tax Court |
James L. Edgar, 6111 E. Skelly, Tulsa, Okla., for the petitioners. Michael J. O'Brien, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent has determined a deficiency in petitioners' Federal income tax for the taxable year 1970 in the amount of $2,323.56 plus an addition to tax under section 6653(a)1 in the amount of $116.18.
The issues for decision are:
(1) Whether, to the extent they remained unpaid, amounts advanced by petitioners to the corporation in which they were majority shareholders represented capital contributions or bad debts. Further, if the sums were bad debts, whether such sums were business or nonbusiness bad debts;
(2) Whether petitioners understated their taxable income for the tax year 1970;
(3) Whether any part of any underpayment of petitioners' income tax liability for the taxable year 1970 was due to negligence or intentional disregard of rules and regulations.2
Some of the facts have been stipulated and are found accordingly.
The petitioners, Andrew J. McAlister, Jr. (Andrew) and Alberta L. McAlister (Alberta), husband and wife, maintained their legal residence in Tulsa, Oklahoma at the time their petition was filed herein. They filed joint Federal income tax returns for the taxable year 1970, using the cash basis method of accounting, with the internal revenue service center in Austin, Texas.
Since 1947 Andrew has been an engineer in the field of construction, services, and repairs relating generally to the oil and gas industry. Andrew was an employee of Warren Petroleum Company until 1959, when he left to become president of Pioneer Drilling Company.
In 1963 Andrew formed a new corporation, Mac Engineering Company, (Mac Engineering) which was primarily engaged in the engineering and construction of natural gas plants and its related facilities. Upon incorporation, Mac Engineering issued 1,500 shares of stock with a par value of $1 each, thereby generating a stated capital of $1,500. From the time of the incorporation in 1963, until the company ceased operation in 1970, petitioners owned at least 70 to 80 percent of the stock of Mac Engineering. As of January 1, 1970 petitioners were the sole shareholders. Andrew was president of Mac Engineering during the life of the corporation.
Beginning on July 3, 1963, petitioners made a series of advances to the corporation. These advances are evidenced by checks issued from petitioners to Mac Engineering on the following dates and in the following amounts:
July 3, 1963 ............ $9,000
March 10, 1965 .......... 7,000
March 12, 1965 .......... 2,5003
December 11, 1967 ....... 450
January 31, 1968 ........ 1,000
February 1, 1968 ........ 500
February 7, 1968 ........ 7,000
September 11, 1969 ...... 1,500
Some of the advances were evidenced by notes and some were not. Notes in the following amounts were executed on the dates indicated by Mac Engineering in favor of petitioners:
July 12, 1963 ........... $9,000
March 10, 1965 .......... 7,000
March 12, 1965 .......... 2,500
December 3, 1965 ........ 3,5004
The advances made by petitioners were otherwise unsecured. Although each of the notes carried an interest rate of 6 percent, no interest was paid on any of the advances. Petitioners characterized the advances as loans, but there were no specific terms for repayment.5
The sums advanced were intended to give Mac Engineering sufficient funds on which to operate. They were typically given to Mac Engineering in order to fund particular jobs. Repayment of the advances depended on the success of the particular operation. Mac Engineering was chronically short of funds.
During 1968 and 1969, Mac Engineering was engaged in the construction of a gasoline plant in Kansas for Kathol Natural Gas Company (Kathol). Sometime in 1969, Kathol ceased making payments to Mac Engineering for the construction work it was performing. Shortly after the cessation of these payments, Andrew suffered a heart attack. By October 1969, the combination of these two events caused Mac Engineering to cease its construction and engineering projects.
Andrew returned to work in early 1970 and attempted to revive Mac Engineering's business. Unfortunately, his efforts were not successful. In June of 1970 an involuntary petition in bankruptcy was filed against Mac Engineering in the United States District Court for the Northern District of Oklahoma. Shortly thereafter, the corporation was adjudicated bankrupt. Most of Mac Engineering's tangible assets had been purchased by Andrew personally a few months prior to the involuntary petition. The only assets listed by Mac Engineering in its schedule of assets was cash of $21.34 and a chose in action against Kathol for $176,880.29.6
The liabilities to unsecured creditors amounted to $65,750.75. Among those liabilities listed was a debt owing to A.J. McAlister, Jr., for $14,809.57. Andrew had received payments from Mac Engineering in 1969 in excess of $16,600.7
On their joint return for 1970, petitioners claimed a bad debt deduction of $18,000 for worthless loans to Mac Engineering. Respondent has disallowed these amounts in full. Petitioners reported $12,000 income from "consulting, self-employment," and $16 interest income for 1970. Thus, adjusted gross income as reported on their return for 1970 was $12,016.
In his statutory notice of deficiency, respondent reconstructed petitioners' income using the source and application of funds method. In finding petitioners had understated their income by $4,739.48, respondent made the following computation:
Application of Funds
Item Amount
Increase Bank Account
Utica Bank
Balance 1/1/70 ........... $ 398.72
Balance 12/31/70 ......... 1,241.20
_________
Increase ................. $ 842.48
Advances to
Mac Engineering .......... 1,245.00
Southland Steel .......... 4,000.00
Personal Living Expense
Food ..................... 2,600.00
Housing .................. 2,721.00
Transportation ........... 1,600.00
Clothing ................. 600.00
Medical .................. 1,700.00
Taxes .................... 847.00
Entertainment and Misc ... 600.00
$10,668.00
__________
Total Application of Funds $16,755.48
__________
Source of Funds
Adjusted Gross Income per
Return .................. $12,016.00
__________
Increased Income ......... $ 4,739.48
During 1970, the McAlister household consisted of 5 persons — petitioners and their 3 daughters.
OpinionOur first task is to determine how much of the sums advanced by petitioners to Mac Engineering remained unpaid in 1970. On their 1970 return petitioners deducted $18,000 as a bad debt. Petitioners now claim that the unpaid balance of the sums advanced to Mac Engineering amounted to $33,805. Respondent has disallowed petitioners' deduction in full, taking the position that petitioners have failed to establish the amount of the advances to Mac Engineering which remained unpaid as of December 31, 1970.
Petitioners have been able to establish, by cancelled checks, advances to Mac Engineering totaling $29,950. The extent to which these advances were repaid by Mac Engineering, however, is less clear. The record suggests a variety of possibilities.
Viewing the evidence as a whole, with particular emphasis on the "Schedules of Bankrupt"8 filed by Mac Engineering, in the bankruptcy proceeding, we have determined that the unpaid advances amounted to $14,809.57.
Having decided the amount of the unpaid advances, the character of these sums must be determined. Petitioners have characterized these advances as bad debts. Respondent, on the other hand, argues that the advances were in fact contributions to capital.
Whether advances to a corporation by shareholders create a debt or constitute contributions to capital is a question of fact on which the petitioner has the burden of proof. Gilbert v. Commissioner 59-1 USTC ¶ 9183, 262 F. 2d 512 (2nd Cir. 1959); Yale Avenue Corp. Dec. 31,556, 58 T.C. 1062 (1972). In determining whether such advances more closely resemble debt or equity the Courts have looked to a number of factors, e.g., the relationship between the parties, whether there is adequate capitalization, whether interest was paid or payable on the advances, whether an outside investor would have made similar investments without security, and whether such advances were placed at the risk of the business and thus constituted risk capital. See O.H. Kruse Grain & Milling v. Commissioner 60-2 USTC ¶ 9490, 279 F. 2d 123 (9th Cir. 1960); Road Materials, Inc. v. Commissioner 69-1 USTC ¶ 9259, 407 F. 2d 1121 (4th Cir. 1969); Gilbert v. Commissioner, supra; Yale Avenue Corp., supra.
The facts here make it clear that petitioners' advances to Mac Engineering represented contributions to capital. No interest was paid on any of the advances. In most cases, the advances were not even evidenced by notes. Aside from the notes, there was no security given for any of the advances. No written agreement establishing the term or condition of the "loans" was executed between petitioners and Mac Engineering. Mac Engineering was under-capitalized and needed the funds in order to operate. These funds were then placed at the risk of the business; repayments depended upon the success of the particular project in which the business was engaged at the time of the advances....
To continue reading
Request your trial