DOJ Argues Corporation Not Entitled to Bad Debt Deduction

Internal Revenue Code of 1986 (26 U.S.C.):

[4] 2. Statements of counsel in open court are equivalent to stipulations and are binding upon the parties. The second issue is whether the Tax Court correctly held that taxpayer's counsel's statement toward the end of the trial that taxpayer was no longer relying on its alternative theory that it was entitled to an interest expense deduction, thereafter precluded taxpayer from asserting that theory.

[6] After a one day trial, the Tax Court (Judge Gerber) issued a memorandum opinion on August 14, 2001 (unofficially reported at 82 T.C.M. (CCH) 435), determining that taxpayer was not entitled to the bad debt deduction and resulting net operating loss carrybacks. (Doc. 21.) On August 21, 2001, the Tax Court entered its decision sustaining the deficiencies determined by the Commissioner. (Doc. 22.)

[7] Taxpayer now appeals. (Doc. 12.)

[9] In 1987, Stewart, Kelso Vernor, and Joseph Busch formed another Texas corporation, Used Power Equipment, Inc. (UPE), together contributing $1,000 in capital in exchange for each receiving one- third of the common stock. (Id. at 3, ¶¶ 9, 10; Doc. 16 at 116.) Taxpayer had no ownership interest in UPE. (Doc. 16 at 114-115.)

[10] UPE's original business was the removal and sale of used machinery from industrial plants. (Docs. 14 at 4, ¶ 12; 16 at 30- 31.) Although UPE made a few sales in its first three years of existence, it had difficulty selling its used equipment. (Doc. 14 at 4, ¶ 14.) From 1987 though 1989, due to low sales and the costs of labor, storage, and other items, UPE suffered losses.² (Doc. 14 at 4, ¶ 14; Exs. 7-R, 8-R, 9-R, 10-R.)

[11] In 1990, Stewart replaced UPE's president and general manager and made himself president. (Doc. 14 at 4, ¶ 13.) UPE's continued losses produced disagreement among the shareholders concerning UPE's future. (Id. at 4, ¶ 14.)

[12] Beginning in March 1990, UPE bid on, and was awarded, several contracts with Formosa Plastics Corporation, U.S.A. (Formosa) to perform work in connection with an expansion of Formosa's Point Comfort ethylene plant. (Doc. 14 at 6, ¶¶ 21-23.) UPE's contractual relationship with Formosa over a period of just over a year consisted of six construction contracts totaling $8,430,963 for the installation of piping and five turbines in Formosa's plant. (Id. at 6, ¶ 25; Doc. 15 at 1, ¶ 61.)

[13] UPE believed that its primary costs in fulfilling the Formosa contracts would be for labor and equipment, as Formosa was to supply the pipe and turbines for the job. (Doc. 14 at 7, ¶ 26.) Although UPE did not expect to incur significant costs for the acquisition of fixed assets, it did not have sufficient working capital to finance the work required under the contracts prior to the receipt of any progress payments from Formosa. (Id. at 7, ¶¶ 27, 28.)

[14] Consequently, in March 1990, UPE received an advance of $250,000 from taxpayer for working capital. (Doc. 14 at 8, ¶ 31.) Taxpayer had obtained the funds for the March advance from a $250,000 loan with Grocers Supply Company (Grocers), a wholesaler of grocery products which also made loans to its customers.³ (Ibid.) A promissory note and security agreement memorialized the loan from Grocers to taxpayer. (Ex. 13-J.) Stewart also personally guaranteed the loan.⁴ (Ibid.)

[15] In late April 1990, UPE received an advance of $475,000 from taxpayer, $75,000 of which it used to redeem the stock of Vernor and Busch, thus making Stewart its sole shareholder. (Doc. 14 at 3,8 ¶¶ 10, 31; Doc. 16 at 53, 64; Ex. 13-J.) The balance of the $475,000 advance was used for working capital ($300,000) and for the purchase of equipment ($100,000). (Doc. 14 at 8, ¶ 31.) Once again, taxpayer had obtained the funds for the April advance by borrowing $475,000 from Grocers. (Ibid.) A promissory note and security agreement memorialized the loan from Grocers to taxpayer, and Stewart again personally guaranteed the loan. (Ex. 13-J.)

[16] In addition to loaning taxpayer the funds for taxpayer's March and April 1990 advances to UPE, in September 1990, Grocers loaned $218,000 directly to UPE for the purchase of equipment. (Ibid.) Grocers took a purchase money security interest in the purchased equipment and Stewart also signed personally for the loan.⁵ (Ex. 14-J; Doc. 16 at 227.)

[17] In October 1990, Grocers made another loan of $300,000 to taxpayer, which in turn advanced the funds to UPE for working capital. (Doc. 14 at 8, ¶ 31.) Stewart again personally guaranteed and signed for this loan. (Ex. 15-J.)

[18] Taxpayer alleged (Docs. 14 at 12, ¶ 58; 15 at 4, ¶ 73; Exs. 38-P; 55-R) that the advances to UPE from taxpayer had been documented by at least 24 separate promissory notes, which, it claimed in its petition (Doc. 1 at 2, ¶ 5(d)), had been prepared contemporaneously with taxpayer's advances to UPE. However, the notes taxpayer produced and relied upon at trial had not been prepared contemporaneously with the advances, but had been prepared later and backdated. (Doc. 16 at 40, 44.) Stewart admitted signing the backdated notes, but testified that he did not know who had prepared them. (Doc. 16 at 119-20.) Stewart also testified that the backdated notes bore a different interest rate than the set of notes purportedly created contemporaneously with the advances. (Doc. 16 at 45-46, 121.) In addition, some of the backdated notes contained references to the Formosa contract job numbers, which, Steward admitted, had not been entered into at the time the purported original notes had been executed. (Id. at 41.)

[19] The accountant who prepared UPE's 1990 corporate tax return testified that she had not been not shown any promissory notes between taxpayer and UPE and had not been informed of their existence or of any advances from taxpayer to UPE. (Id. at 215-216.) UPE's 1990 tax return (Ex. 10-J, see Ex. 11-R) did not report any accrued interest expense with respect to the advances from taxpayer, nor did taxpayer's tax returns report any accrued interest income with respect to the advances to UPE (Doc. 16 at 106, 108-109, 175, 200, 211-212, 215-219, 222; Exs. 10-J; 11-R).

[20] Although UPE had received progress payments totaling $7,778,963 from Formosa (approximately 93% of the $8,430,963 aggregate original contract amount) (Doc. 16 at 122-23; Exs. 26-R; 27-R), disputes arose between UPE and Formosa. (Doc. 14 at 10, ¶ 49.) In April 1992, UPE sued Formosa for damages totaling $2,082,000. Docs. 14 at 10-11, ¶ 50; 16 at 122-123; Exs. 26-R; 27-R). The lawsuit eventually settled in 1994, and taxpayer received a net recovery of $227,114. (Doc. 14 at 11, ¶ 54.) After the settlement, taxpayer decided there was no reasonable prospect of recovering the balance of its advances to UPE. (Id. at 12, ¶ 55.)

[21] On its 1994 tax return, taxpayer thus claimed a bad debt deduction of $1,352,433, representing the unrecovered advances it had made to UPE.⁶ (Docs. 14 at 9-10, 12, ¶¶ 41-48, 56; Doc. 15 at 3, ¶¶ 70, 71; 16 at 197-224; Exs. 20-R to 25-R, 52-R, 53-P.) The deduction was the basis for a claimed net operating loss that was carried back to taxpayer's 1991 and 1992 tax years.⁷ (Docs. 1, attached Ex. A at 4-5; 21 at 11; Ex. 1-J at 8.)

[22] On October 19, 1998, the Commissioner sent taxpayer a statutory notice of deficiency disallowing both the bad debt deduction claimed for 1994 and the resulting net operating loss deductions for 1991 and 1992. (Ex. 1-J.) The notice stated that taxpayer had failed to show that the amount in excess of that allowed was a bona fide bad debt and not a contribution to capital. (Id. at 8.) As a result, taxpayer's taxable income was increased, resulting in deficiencies of $216,552 for 1991, $225,336 for 1992, and $8,190 for 1994. (Ex. 1-J.)

[23] On January 19, 1999, taxpayer filed its Tax Court petition contesting the deficiencies. (Doc. 1.) Specifically, taxpayer's petition alleged that taxpayer's intent to make loans to UPE (as opposed to capital contributions) was "evidenced by promissory notes entered into at the time of the loans, reasonable rates of interest, a reasonable expectation of repayment, and consistently treating them as loans on their books and records." (Doc. 1 at 2, ¶5(d).) Taxpayer also alleged that UPE had been adequately capitalized at all times. (Id. at 2, ¶ 5(e).)

[24] On November 17, 1999, taxpayer amended its petition, asserting as an alternative position that a portion of the bad debt included $463,559 in interest paid to Grocers, which it otherwise was entitled to deduct. (Doc. 9 at Ex. A.)

[25] On May 22, 2000, a one-day trial was held. (Doc. 13.) At trial, before the presentation of taxpayer's last witness, the following discussion took place on the record (Doc. 16 at 223-224 (emphasis added)):

[27] Taxpayer now appeals.

[29] This Court, as have many others, has developed a non- exhaustive set of factors to aid in making the fact-specific determination whether an advance is a loan (debt) or capital contribution (equity). Not every factor is present in each case and the object of the inquiry is not to count factors, but to evaluate them. That is what the Tax Court did here. It considered all the factors developed by this Court and concluded that the factors presented by this case indicated that taxpayer's advances were contributions to UPE's capital and not true debt.

[30] In the first instance, the court found telling the fact that UPE was thinly capitalized, having only $1,000 in paid-in capital and an inventory of used equipment for which it had paid little or nothing and which it ultimately sold as scrap for $25,000. The $1,335,433 in advances, which UPE failed to repay and for which taxpayer claimed a bad debt deduction, thus dwarfed UPE's other assets. Indeed, without the infusion of taxpayer's advances, taxpayer lacked sufficient capital to operate its business.

[31] Second, taxpayer subjected itself to the risks of UPE's business in making advances. It neither sought nor received security for the advances, had no expectation of repayment from anything other than UPE's earnings, if any, and postponed indefinitely any obligation of UPE to repay the advances, instead permitting its interests to be subordinated to the interests of UPE's other creditors.

[32] Third, neither taxpayer nor UPE treated the advances as loans on their respective books and records. Taxpayer neither recorded any accrued interest income on its books nor reported any on its income tax returns. Indeed, taxpayer had not even informed its accountant of the advances or provided her with any documentation concerning them.

[33] Indeed, the lack of documentation to indicate that the advances were intended to be loans was among the other factors considered by the Tax Court in reaching its decision. Although taxpayer claimed that the advances had been made in exchange for promissory notes from UPE, the only notes that taxpayer produced at trial were ones that had been prepared in connection with other litigation and backdated. These and other factors considered by the Tax Court amply support its decision, and taxpayer's contentions to the contrary are without merit.

[34] 2. The Tax Court was also correct in holding that the statement of taxpayer's counsel toward the end of the trial that taxpayer was no longer relying on its alternative interest expense theory, precluded taxpayer from thereafter asserting that theory. It is settled law that statements of counsel in open court are binding on their clients. Taxpayer's counsel made no attempt to clarify or to retract his statement at the time. Although taxpayer now contends that its counsel did not intend to concede the issue completely, that was not the way the statement was understood by either the Commissioner or the Tax Court. The Commissioner had understood the statement to be a complete concession of the issue, because the amount of the alleged interest payment had not been established, there was no evidence that any interest had been paid, and the amounts claimed to have been paid had been consolidated into a new loan. The Tax Court was correct to hold taxpayer to its concession. The decision of the Tax Court should be affirmed.

A. Introduction

[36] In the case of a corporation,⁸ Section 166(a) of the Internal Revenue Code provides, in relevant part, that "[t]here shall be allowed as a deduction any debt which becomes worthless within the taxable year." However, in order to be deducted as worthless, the debt must be bona fide, that is, it must be "a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money." Treas. Reg. § 1.166-1(c). In contrast, a contribution to the capital of a corporation "shall not be considered a debt for purposes of section 166." Ibid. This last is a reflection of Section 263 of the Code, which allows no deduction for a capital expenditure. Thus, a voluntary contribution by a corporate shareholder to the capital of the corporation for any corporate purpose is a nondeductible capital expenditure, Treas. Reg. § 1.263(a)-2(f), as is a contribution to the capital of a corporation made by a nonshareholder, see Treas. Reg. § 1.118-1. As a result, while "[d]ebt-equity questions commonly involve a corporation and its shareholders-the issue being whether monies advanced by the shareholder to the corporation constitute a loan or a contribution to capital," such questions may also arise where, as here, the issue concerns advances made by one corporation to another affiliated corporation. Texas Farm Bureau v. United States, 725 F.2d 307, 308 (5th Cir. 1984).

[37] The question whether an advance is a loan or a contribution to capital is fact-specific and "courts frequently have to go beyond the form and into the substance of the particular transaction." Texas Farm Bureau, 725 F.2d at 308. In making this inquiry, this Court has developed a non-exhaustive set of factors to be examined:

These factors "are designed to disclose the real nature of the transaction in question-that is whether it exhibits the characteristics of a bona-fide loan to the corporation which is expected, indeed, may be compelled, to be repaid in full at some future date, or whether as a formalized attempt to achieve the desired tax result while lacking in necessary substances, it merely parades under the false colors of such a transaction." Tomlinson v. The 1661 Corp., 377 F.2d 291, 295 (5th Cir. 1967).

[38] While these factors are commonly relevant to debt-equity determinations, not every factor is present in each case and "[t]he object of the inquiry is not to count factors, but to evaluate them." Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969); accord Texas Farm Bureau, 725 F.2d at 311; Slappey Drive Indus. Park v. United States, 561 F.2d 572, 581 (5th Cir. 1977). Each case, therefore, turns on its own facts, and differing circumstances "may bring different factors to the fore." Slappey Drive Indus. Park, 61 F.2d at 581.

[40] 1. UPE was thinly capitalized. Thin capitalization is "very strong evidence of a capital contribution." Estate of Mixon, 464 F.2d at 408; see Indian Lake Estates v. United States, 448 F.2d 574, 579 (5th Cir. 1971) (technical $1,000 capitalization can be better characterized as illusory rather than thin). The Tax Court correctly concluded (Doc. 21 at 16) that UPE was thinly capitalized, a fact that "weigh[ed] heavily" against the taxpayer. Taxpayer claimed a bad debt deduction for $1,352,433, which it had advanced to UPE and had not been repaid. But UPE had only $1,000 in paid-in capital and its other assets were of questionable value. Its entire inventory was salvage for which it had paid nothing (Doc. 16 at 31) and which-with one exception-had never been offered to Grocers (or taxpayer) as collateral (Doc. 16 at 133).

[41] Although taxpayer asserted below and continues to assert on appeal (Br. 20) that UPE's inventory of salvaged used equipment was worth $100 million, the only evidence to support that figure was the self-serving and unconvincing testimony of Stewart and of UPE's former president, which the Tax Court was free to disregard. See Potito v. Commissioner, 534 F.2d 49, 51 (5th Cir. 1976) (Tax Court is not required to accept taxpayer's self-serving testimony where it is inherently improbable or unreasonable); cf. Anderson v. City of Bessemer City, 470 U.S. 564, 575 (1985) (credibility determinations can almost never be clearly erroneous because "only the trial judge can be aware of the variations in demeanor and tone of voice that bear so heavily on the listener's understanding of and belief in what is said"). This is particularly true given the fact that (1) the inventory was not so valued on UPE's books, Doc. 21 at 16-17; (2) the inventory had not been appraised, id. at 17; (3) aside from a few minor sales, the inventory was sold for scrap for approximately $25,000, id. at 17; Doc. 16 at 150, 163; and (4) Vernor's and Busch's UPE shares were redeemed for only $75,000, id. at 8.⁹ Clearly, the Tax Court was correct to reject taxpayer's improbable claim that the inventory was worth $100 million.

[42] Moreover, as recognized by the Tax Court, in situations where the entity is so thinly capitalized that significant portions of the initial infusions are used to acquire assets without which the corporation would not begin functioning, the infusions are traditionally seen as capital contributions rather than debt. Slappey Drive Indus. Park, 561 F.2d at 583; Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712, 722 (5th Cir. 1972). Such was the case here. Without taxpayer's advances, UPE would not have been able to continue its salvage operations, purchase equipment, or perform under the Formosa Contracts. (Doc. 21 at 17.) Even after receiving some of the progress payments under the Formosa contract, UPE still needed infusions of cash to maintain its operations.¹⁰ (Id. at 17-18.)

[43] 2. UPE's earnings were the only possible source of repayment and taxpayer's interests were in fact subordinated to the interest of other UPE creditors. "[I]f repayment is possible only out of corporate earnings, the transaction has the appearance of a contribution of equity capital." Estate of Mixon, 464 F.2d at 405. A creditor expects to be repaid regardless of whether the debtor's business does poorly. Thus a dependence on earnings for repayment of advances indicate the advances were not debt. See Texas Farm Bureau, 725 F.2d at 313; Midland Distribs., Inc. v. United States, 481 F.2d at 733-734 (advances subject to fortunes of venture for full payment indicate equity contribution). Again, such was the case here. The record here is devoid of any evidence that taxpayer expected its advances to be repaid from anything other than UPE's earnings.

[44] Taxpayer's suggestion (Br. 17) that taxpayer looked to UPE's gross receipts (as opposed to profits or net earnings) for repayment, is belied by the facts. Although UPE received progress payments totaling $7,778,963 from Formosa (Doc. 16 at 122-123; Exs. 26-R and 27-R), it did not use those receipts to repay taxpayer. On the contrary, the receipts were used to pay other creditors first (Doc. 16 at 110), and when problems developed on the Formosa contracts, UPE failed to repay taxpayer's advances (Doc. 21 at 16).

[45] Taxpayer's assertion (Br. 18) that there is no evidence that its advances were subordinated to the interests of other creditors is simply wrong. Stewart testified that all of the UPE creditors other than taxpayer were paid in full.¹¹ (Doc. 16 at 109-110.) UPE thus had had opportunity to repay taxpayers advances from the progress payments it received under the Formosa contracts, but failed to do so. (Id. at 15-16.) That taxpayer's advances were in fact subordinated to the interests of other creditors is a telling factor that weighs against treating the advances as debt. See Estate of Mixon, 464 F.2d at406. To use the Tax Court's phrase (Doc. 21 at 15), UPE's "habitual postponement" of its purported obligation to repay the advances indicates that taxpayer's advances to UPE were subordinated to other creditors to keep Stewart's investment in UPE viable. (Id. at 16.) That investment had all the characteristics of equity, not debt.

[46] 3. Neither taxpayer nor UPE treated taxpayer's advances as debt on their books and records. The Tax Court correctly found significance in the fact that neither taxpayer nor UPE treated taxpayer's advances as loans or debt on their respective financial records. (Doc. 21 at 15.) Indeed, taxpayer's allegation in its petition (Doc. 1 at 2, ¶5(d)) that the intention of taxpayer to treat the advances as loans was evidenced by "consistently treating them as loans on their [sic] books and records" is not supported by one scintilla of evidence and is contradicted by their records. Indeed, UPE's accountant testified that she had not even been informed that taxpayer had made advances to UPE, let alone been provided with any supporting documentation. (Doc. 16 at 215-126.) Moreover, taxpayer did not report on its tax returns any accrued interest income with respect to the advances, nor did UPE report any correlative interest expense on any of its returns. (Doc. 21 at 15.) Under the circumstances, taxpayer's contention (Br. 19-20) that these advances were intended as loans is without merit.

[47] 4. The objective facts indicate that the parties did not intend the advances to be loans. Whether an advance is to be treated as debt or equity is not a matter of the parties' subjective intent. The creation of a true indebtedness "requires more than a declaration of intention to create an indebtedness and more than the existence of corporate paper encrusted with the appropriate nomenclature captions." Tyler, 414 F.2d at 850. A court must "look not to mere labels or to the self-serving declarations of the parties, but to the more reliable criteria of the circumstances surrounding the transaction." Ibid; see Texas Farm Bureau, 725 F.2d at 314. Contrary to taxpayer's assertion (Br. at 19) that the Tax Court should have placed more weight on Stewart's testimony regarding the intent of the parties, the Tax Court was correct to disregard his self-serving testimony on this issue. See Estate of Mixon, 464 F.2d at 407 (subjective intent on part of an actor will not alter the relationship or duties created by an otherwise objectively indicated intent). In the instant case, the Tax Court's finding that the parties had not intended to create a bona fide indebtedness is well supported by such objective evidence as their failure to treat the advances as loans on their books or to report, as appropriate, either interest income or expense on their income tax returns.

[48] 5. Taxpayer's advances resulted in Stewart's obtaining complete ownership of and control over UPE. As the Tax Court correctly observed (Doc. 21 at 14), taxpayer "was Stewart's instrumentality for equity investment in UPE." Taxpayer was wholly owned by Stewart, who used taxpayer's resources to eventually buy out Vernor and Busch and to acquire 100% of the stock of UPE. (Ibid.) Upon gaining control of UPE, Stewart installed himself as president. (Ibid.) Such identity of interest and control is further evidence that taxpayer's advances were intended as capital contributions. See Estate of Mixon, 464 F.2d at 409.

[49] 6. There was no credible evidence that taxpayer's advances had been made in exchange for promissory notes from UPE. If the presence of certificates of indebtedness is some indicia that loans were intended, the absence of such documents is some indicia that advances were intended as equity. See Estate of Mixon, 464 F.2d at403. Contrary to taxpayer's contention (Br. 14- 16), the Tax Court correctly placed little significance on the 24 promissory notes taxpayer offered at trial in support of its contention that the advances were loans. (Doc. 21 at 18-19.) The notes had not been "entered into at the time of the [advances]" as taxpayer had asserted in its petition (Doc. 1 at 2, ¶5(d)), but rather were backdated documents that had been prepared for UPE's law suit against Formosa. (Doc. 16 at 42-44, 119- 120.) Although Stewart testified that the notes represented reconstructions of allegedly original notes that had somehow been lost or destroyed, he also testified that he was unable to remember the circumstances under which they had been created, who had prepared the notes, or who had instructed his secretary (and notary) to back- date them. (Doc. 16 at 40-42, 119-120.) In addition, Stewart testified that some of the notes made reference to the Formosa contracts, which postdated taxpayer's advances to UPE. (Id. at 41.) Finally, Stewart testified that at least two of the notes bore interest rates lower than the interest rates on the alleged original notes. (Id. at 44-46.) Faced with such testimony, the Tax Court correctly concluded that the record was insufficient to find that notes had in fact been executed at the time of taxpayer's advances to UPE.¹² (Doc. 21 at 19.) "Considering the failure to advise the accountants of the advances, failure to book interest income, and failure to book the advances as loans, it is unlikely that [taxpayer] went through the formality of notes at the time the funds were advanced to UPE." (Ibid.)

C. Taxpayer's remaining arguments are without merit

[50] 1. Taxpayer's assertion (Br. at 10) that the Tax Court "ignored" any of the factors set forth in Estate of Mixon, is both factually in error and legally without significance. As for the first, the Tax Court explicitly stated that it had considered all the Estate of Mixon factors in coming to its decision. (Doc. 21 at 13 n.5.) As for the latter, this Court has consistently held that not every factor need be considered in a given case. See Texas Farm Bureau, 725 F.2d at 311; Slappey Drive Indust. Park, 561 F.2d at 581; Tyler, 414 F.2d at 848. Each case turns on its own facts, and differing circumstances "may bring different factors to the fore." Texas Farm Bureau, 725 F.2d at 311.

[51] 2. Taxpayer's contention (Br. 16) that the presence of a fixed maturity date on the promissory notes it produced at trial should have been given weight by the Tax Court ignores the fact that taxpayer failed to prove that any notes had been issued at the time of its advances to UPE. The notes offered at trial were ones that had been prepared in connection with UPE's lawsuit against Formosa and that had been backdated. (Doc. 16 at 40-42, 119-120.) As the Tax Court was correct not to give weight to these notes, it was equally correct to ignore the maturity dates contained therein.

[52] 3. Taxpayer's contention (Br. at 17) that the Tax Court ignored the fact that taxpayer had the right to enforce repayment in the promissory notes is likewise without merit. Again, the Tax Court was correct to ignore the terms contained in the notes produced at trial, which had been created after taxpayer's advances had been made. This is all the more true, given that Stewart was the president and sole shareholder of both UPE and taxpayer, repayment was within his sole control, and he in fact postponed repayment for years. As this Court has noted, under such circumstances, any right to enforce repayment is "only a mirage." Texas Farm Bureau, 725 F.2d at 313.

[53] 4. Taxpayer's contention (Br. at 18) that taxpayer did not gain any increased management control over UPE as a result of the advances is wide of the mark. Taxpayer was Stewart's instrumentality throughout,¹³ and it was Stewart's increased control over UPE that was relevant. See, e.g., Texas Farm Bureau, 725 F.2d at 310-11 (advances from corporate entity to another corporate entity given the same special scrutiny as a transaction between a corporation and its shareholders when one corporation is functioning as an organizational proxy for its members). As to that, the facts are undisputed: as a result of taxpayer's advances, Stewart increased his ownership of and control over UPE to 100%.

[54] 5. Contrary to taxpayer's claim (Br. 23),the fact that UPE had been able to obtain one, fully-secured loan directly from Grocers does not mean that the Tax Court erred in finding that UPE otherwise did not have sufficient capital assets to satisfy Grocers' security requirements for additional loans. James Nelson, Grocers' vice president, testified that when Stewart had approached him about additional loans for the UPE Formosa projects, he had told Stewart he would only loan money to taxpayer (not UPE) due to his concerns about the lack of security. (Doc. 16 at 226.) Certainly UPE was in no position to receive unsecured advances from outside lenders.¹⁴

[55] 6. Taxpayer's contention (Br. 23) that the Tax Court erred in finding that, at its inception, UPE used some of taxpayer's advances to acquire capital assets is contradicted by Stewart's own testimony. Stewart himself stated that, upon its start-up in 1987, UPE had borrowed money from taxpayer to acquire used equipment. (Doc. 16 at 36-40.) In any event, the use made of the funds advanced in 1987 is of lesser moment than the fact that the funds advanced in 1990, which gave rise to the claimed bad debt deduction, were needed, among other things, to purchase a total of $318,000 in equipment for the Formosa project. (Ibid.) As Stewart testified, when it bid on the Formosa contracts, UPE had not had enough money to perform thereunder. ¹⁵ (Doc. 14 at 56.) That UPE needed the advances to begin performing under the contracts is further evidence that the advances were an equity investment and not debt. See Texas Farm Bureau, 725 F.2d at 314 (the purchase of such "necessary first assets" points away from a finding of debt); Slappey Drive Indus. Park, 561 F.2d at 583.

[56] 7. Finally, while taxpayer may be "troubled" (Br. 24) by the Tax Court's use of the adjective "habitual" to describe the repeated postponements of any obligation of UPE to repay taxpayer's advances, the fact of the matter is that most of the advances were not repaid, despite the fact that payments were made to UPE's other creditors. (Doc. 14 at 9, ¶ 42; Doc. 16 at 110-114). What is perhaps even more telling here than the "habitual postponement" of any repayments, however, is that taxpayer continued to advance money to UPE after UPE failed to meet the repayment obligations purportedly created by earlier advances. (Doc. 16 at 110, 230-31; see Doc. 21 at 16.) Such behavior was inconsistent with that of a true lender. See, e.g., Texas Farm Bureau, 725 F.2d at 314 (taxpayer not concerned with interest on advances, rather, like an equity investor, it was concerned with continued operation).

[58] In its amended petition (Doc. 9), taxpayer had asserted that the amount it had claimed as a bad debt deduction included some $463,559 that was deductible as interest under Section 163 of the Code. Taxpayer allegedly meant thereby to assert that it would be entitled to deduct this amount as interest, in the event the court held it was not entitled to deduct the larger sum as a bad debt. Prior to calling his last witness, taxpayer's counsel stated, "I will agree that the 463,559 alternative theory is not something the Petitioner is currently relying upon." (Doc. 16 at 224.) As a result, counsel for the Commissioner did not attempt to examine taxpayer's witness on the subject and did not address the issue in his opening post-trial brief. (Docs. 16 at 223-224; Doc. 17 at 2, 19.) Consequently, the Tax Court held (Doc. 21 at 11, n.3) that taxpayer had conceded the issue and was therefore precluded from asserting it in its post-trial brief.

[59] Taxpayer's contention (Br. 25-31) that the Tax Court erred in finding that taxpayer had conceded its alternative interest expense deduction theory is without merit. Contrary to taxpayer's suggestion (Br. 29-31), statements of counsel in open court are binding upon their clients. See Church of Scientology v. Commissioner, 83 T.C. 381, 523-24 (1984), aff'd 823 F.2d 1310 (9th Cir. 1987); Heights Citizens Ass'n v. Embassy Corp., 433 F.2d 513, 515 (D.C. Cir. 1970). Although taxpayer now contends that its counsel did not intend to concede the issue completely, its counsel made no attempt to qualify his statement at the time and that was not the way the statement was understood by either the Commissioner or the Tax Court. As the Commissioner explained in reply after taxpayer had reasserted the issue in its opening brief, the Commissioner had understood counsel's statement to be a complete concession, because the amount of interest allegedly paid to Grocers had not been established,¹⁶ there was no evidence that any interest payments had been made, and amounts claimed to have been paid had been actually consolidated into a new loan. (Doc. 19 at 68- 69.) Since taxpayer had failed to prove any entitlement to an interest deduction, the Commissioner had understood taxpayer to be withdrawing the claim. (Ibid.)

[60] Taxpayer concedes (Br. 25, n.7) the Tax Court's finding on this issue is reviewed for clear error. Although taxpayer may have a different understanding of its counsel's statement, "where there are two permissible views of the evidence, the factfinder's choice between them cannot be clearly erroneous." Anderson, 470 U.S. at 574.

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3. THE UNDERSIGNED UNDERSTANDS A MATERIAL MISREPRESENTATION IN COMPLETING THIS CERTIFICATE, OR CIRCUMVENTION OF THE TYPE-VOLUME LIMITS IN Fed. R. App. P. 32(a)(7), MAY RESULT IN THE COURT'S STRIKING THE BRIEF AND IMPOSING SANCTIONS AGAINST THE PERSON SIGNING THE BRIEF.

²UPE's most significant transaction was in 1990, when it earned a commission of $450,000 by brokering a sale of equipment it did not own. (Doc. 16 at 33, 48, 99.) Its only other sales between 1987 and 1989 were for parts and three pieces of equipment. (Id. at 155-156.) The used equipment inventory of UPE was eventually sold for scrap, in Stewart's description, for "just pennies," (less than $25,000). (Id. 132, 134, 150, 163.)

³Grocers frequently made loans to its customers for working capital, store renovation, expansion, and other purposes. (Doc. at 14 at 5, ¶ 18.) Grocers normally required its loans to be secured by the borrower's inventory, furniture, fixtures, receivables, and other assets. (Id. at 14 at 5, ¶ 19.) When borrowers default, and satisfactory extension of repayment terms cannot be negotiated, Grocers enforces its security agreements by taking possession of and liquidating the secured assets. (Ibid.) Grocers' policy was not to get involved in the operation of the retail stores or become an equity investor or stockholder of the borrowers. (Ibid.)

⁴Although Stewart testified that he believed there were documents memorializing this advance between taxpayer and UPE, he was unable to produce any or to account for the documents' whereabouts. (Doc. 16 at 63.) Documents allegedly memorializing other advances from taxpayer to UPE are discussed below.

⁵A $111,984 balance remaining on this only loan made directly to UPE by Grocers was eventually satisfied by taxpayer (although it was not liable on the loan) when neither UPE nor Stewart personally could repay the debt. (Docs. 16 at 113, 206; 21 at 8.)

⁶Included in the claimed deduction was the $111,985 balance of UPE's direct obligation to Grocers that taxpayer had paid. (Docs. 16 at 206; 21 at 11; Ex. 36-R (at 245).) See note 5, supra.

⁷Taxpayer claimed net operating loss deductions of, respectively, $636,917 and $662,756 for its 1991 and 1992 taxable years.

⁸In the case of a noncorporate taxpayer, a deduction is allowed only for business bad debts; nonbusiness bad debts are treated as short-term capital losses. I.R.C. § 166(d).

⁹If as taxpayer contends (Br. at 20) there had been no need to appraise the inventory, because Vernor and Busch were knowledgeable about its value, the fact that they were willing to be bought out for $75,000 amounts to a concession that UPE's inventory was worth about one-tenth of one percent of the $100 million claimed.

¹⁰Taxpayer's contention (Br. 21) that UPE was not thinly capitalized, because there was no expectation that its debt- to-equity ratio would increase, is unsupported by the facts. UPE's debts were high in relation to its total equity of only $1,000. (Doc. 21 at 16.) Between labor, storage, and other costs, and its low sales, it sustained losses every year it filed a corporate tax return. (Doc. 14 at 4, ¶ 14.) Moreover, as UPE had no working capital to finance the Formosa contracts and needed infusions of capital to commence and sustain its operations, it was foreseeable that its debt would increase, not decrease.

¹¹Taxpayer's citation (Br. at 18) to the trial transcript (Doc. 16 at 111-112) for evidence that other creditors were not paid in full appears to be an error.

¹²Taxpayer's assertion (Br. 14)that the notation "Loan to UPE" written on some of its checks to UPE (Ex. 39-P) amounts to "contemporaneous corroborating evidence" that the advances were loans is undercut by the fact that at least an equal number of the documents in this exhibit contain the notation "transfer." (Ibid.)

¹³Taxpayer's objection (Br. at 22) to the Tax Court's conclusion (Doc. 21 at 14) that taxpayer had been acting as Stewart's instrumentality is amply rebutted by the record.

¹⁴Although taxpayer asserts (Br. 23) that it had received a loan from First Bank of Sweeney, there is insufficient information (Doc. 16 at 117) in the record to establish when or on what terms this loan had been made; and the assertion is at odds with Stewart's testimony (id. at 57) that UPE had not even attempted to contact any lenders other than Grocers.

¹⁵This is hardly surprising, since UPE had only $1,000 in paid-in capital (Doc. 16 at 116) and had reported losses for every year it had been in existence (Doc. 14 at 4, ¶ 14).

¹⁶The amount taxpayer sought to recharacterize as interest had not appeared on its accountant's work papers (Exs. 22-R, 36-R) and the vice president of Grocers (to whom the interest allegedly had been paid), had been unable to explain or verify the figure. (Docs. 16 at 229-230; 19 at 68.)