Pyron v. Commissioner

MEMORANDUM FINDINGS OF FACT AND OPINION *202

WELLS, Judge: Respondent determined a deficiency of $ 156,964 in petitioners' 1990 Federal income tax.

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

After concessions, ¹ the issues to be decided are as follows:

1. Whether petitioners are entitled to deduct for taxable year 1990 the portion of a loss carryforward attributable to a bad debt deduction claimed by petitioners on their amended 1989 tax return for the worthlessness of loans made by petitioner Stan Pyron to a mining company; and *203

2. whether petitioners are entitled to a business bad debt deduction for taxable year 1990 for the worthlessness of loans made by petitioner to a mining company.

*204 FINDINGS OF FACT

Some of the facts have been stipulated for trial pursuant to Rule 91. The parties' stipulations of fact are incorporated herein by reference and are found as facts in the instant case.

At the time they filed their petition in the instant case, petitioners resided in Florence, Montana.

During 1979, petitioner Stan Pyron (petitioner) and Gerald Dalton began investing in a Chilean copper mine of a mining company called Compania Minera Esperanza (CME). During 1984 or 1985, petitioner and Mr. Dalton formed Compania Minera Adventura (CMA), which leased the copper mines and the plant from CME.

During 1988, in order to terminate their relationship and to pay an outstanding debt that he owed to petitioner, Mr. Dalton transferred his entire interest in CME to petitioner. Prior to Mr. Dalton's transfer of his CME interest, petitioner never requested or demanded from Mr. Dalton any payment on loans allegedly made by petitioner to Mr. Dalton.

Petitioner advanced money to CME and/or CMA and alleges that such advances were loans. Petitioner held the power of attorney for CME. For petitioner's advances to CME/CMA, notes were prepared establishing interest rates and maturity*205 dates, but no repayment schedules were prepared and no collateral for the notes was given. On the maturity dates of the notes, petitioner did not pursue collection of either the principal of or the interest due on the notes.

During 1990, petitioner sold his interest in CME. Petitioners provided no books, records, or tax returns with respect to their interest in CME/CMA.

OPINION

The issue we must resolve in the instant case is whether petitioners are entitled to two bad debt deductions pursuant to section 166(a) (1) for the worthlessness of loans allegedly made by petitioner to CME/CMA. The first bad debt deduction, claimed by petitioners on their 1989 amended return, was for the worthlessness of loans allegedly made by petitioner to CME/CMA in the amount of $ 633,897. As a result of their deduction of that loss, petitioners reported on their 1989 amended return a net operating loss which subsequently was carried forward to petitioners' 1990 return. Respondent argues that petitioner's advances were not bona fide debt but, rather, contributions to capital. Consequently, in the notice of deficiency, respondent disallowed the portion of the loss carryforward on petitioners' 1990 tax*206 return attributable to the bad debt deduction in the amount of $ 633,897 claimed by petitioners on their 1989 amended return and recharacterized such amount as $ 64,085 in short-term capital loss and $ 460,526 in long-term capital loss.

The second bad debt deduction, claimed by petitioners on their 1990 return, was for the worthlessness of loans allegedly made by petitioner to CME/CMA in the amount of $ 4,010. Respondent argues that petitioner's advances were not bona fide debt but, rather, contributions to capital. Consequently, in the notice of deficiency, respondent disallowed the deduction and increased petitioners' taxable income; respondent, however, did not recharacterize the amount as a capital loss. As an alternative argument, respondent argues that the advances, if they are considered bona fide debt, are nonbusiness bad debts deductible only to the extent permitted pursuant to section 166(d).

As to both bad debt deductions, petitioners contend that they are entitled to deduct the loans as ordinary losses. Alternatively, petitioners argue that the mining companies, CME and CMA, are partnerships and that, therefore, petitioners are entitled to deduct their distributive share*207 of the mining partnerships' losses against ordinary income for each taxable year. ²

Section 166(a) (1) provides, in general, for the deduction of debts that become wholly worthless during a taxable year. Section 166, however, distinguishes between business bad debts and nonbusiness bad debts. Sec. 166(d); sec. 1.166-5(b), Income Tax Regs. Business bad debts may be deducted against ordinary income if they become wholly or partially worthless during the year (in the case of the latter, to the extent charged off during the taxable year as partially worthless debts). Sec. 1.166-3, Income Tax Regs. To qualify for the business bad debt deduction, the taxpayer*208 must establish that the debt was proximately related to the conduct of the taxpayer's trade or business. United States v. Generes, 405 U.S. 93, 103 (1972); sec. 1.166-5(b), Income Tax Regs.

Nonbusiness bad debts, on the other hand, may be deducted, but only if they become entirely worthless during the year claimed; they are, moreover, to be treated as short-term capital losses. Sec. 166(d). Generally, a nonbusiness bad debt is a debt other than a debt (1) created or acquired in the trade or business of the taxpayer or (2) the loss from the worthlessness of which is incurred in a trade or business of the taxpayer. Sec. 166(d) (2). The question of whether a debt is a nonbusiness bad debt is a question of fact. Sec. 1.166-5(b), Income Tax Regs.

A deduction for a bad debt is limited to a bona fide debt. Sec. 1.166-1(c), Income Tax Regs. A bona fide debt is a debt that "arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money." Id. For purposes of section 166, a contribution to capital is not considered a debt. In re Uneco, Inc., 532 F.2d 1204, 1207 (8th Cir. 1976);*209 Kean v. Commissioner, 91 T.C. 575, 594 (1988); sec. 1.166-1(c), Income Tax Regs.

Deductions are a matter of legislative grace, and petitioners bear the burden of proving that they are entitled to the deductions claimed. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934). Taxpayers are required to maintain records that are sufficient to enable the Commissioner to determine their correct tax liability. See sec. 6001; Meneguzzo v. Commissioner, 43 T.C. 824, 831-832 (1965); sec. 1.6001-1(a), Income Tax Regs. Moreover, a taxpayer who claims a deduction bears the burden of substantiating the amount and purpose of the item claimed. Hradesky v. Commissioner, 65 T.C. 87, 90 (1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976); sec. 1.6001-1(a), Income Tax Regs.

Characterization of an advance as either a loan (i.e., debt owed to the lender) or capital contribution (i.e., equity held by claim that Real McCoy's deduction should not be allowed*210 until an equal amount of income is recognized by Mack McCoy. Generally, section 267 requires accrual basis taxpayers to defer deductions for amounts payable to a related person, as specified in 267(b), until such time as the amount is includible in the recipient's gross income.

We need not make a determination as to whether petitioner's situation falls within the specified relationships found within section 267(b). ²Section 1.267(a)-1(c), Income Tax Regs., reflects a general principle of tax law that no deduction is allowed for an unpaid expense that arises from a transaction that is not bona fide. We find that the Real McCoy's alleged liability did not arise from a bona fide arm's-length transaction. Rather, as the record reveals, the liability arose from a dubious transaction carried out in petitioner's own mind and is not supported by economic reality. Petitioner's attempt to use differing methods of reporting income in order to obtain this artificial deduction will not be permitted.

*211 For the above reasons, we hold that petitioners are not entitled to deduct the $ 15,000 as an accrued business expense under section 162. We, therefore, do not have to decide whether their method of accounting for that deduction clearly reflects income.

We next consider whether petitioners are liable for the section 6662(a) accuracy-related penalty asserted against them. We hold that they are.

Section 6662 imposes a penalty equal to a 20-percent portion of the underpayment attributable to, inter alia, negligence or disregard of rules or regulations. "Negligence" includes failure to make a reasonable attempt to comply with the law, and the term "disregard" includes careless, reckless, or intentional disregard. Sec. 6662(c). The penalty does not apply to any portion of an underpayment for which there was reasonable cause and with respect to which the taxpayer acted in good faith. Sec. 6664(c); sec. 1.6664-4(a), Income Tax Regs. The Commissioner's determination imposing the accuracy-related penalty is presumed correct, and the taxpayers bear the burden of proving that they are not liable. Rule 142(a); Tweeddale v. Commissioner, 92 T.C. 501, 505 (1989).*212

Petitioner's only contention raised as a defense to the accuracy-related penalty is his reliance on respondent's Publication 334, entitled "Tax Guide for Small Business". Petitioner indicated that the following two paragraphs on page 11, of the 1993 tax year version, support his deduction and establish that his method of accounting for that deduction clearly reflects income:

Business and personal items. You may account for business and personal items under different accounting methods. Thus, you may figure the income from your business under an accrual method even though you use the cash method to figure personal items.

Two or more businesses. If you operate more than one business, you generally may use a different accounting method for each separate and distinct business if the method you use for each clearly shows your income. For example, if you operate a personal service business and a manufacturing business, you may use the cash method for the personal service business but you must use the accrual method for the manufacturing business. [Emphasis added.]

Petitioner's reliance on the above passages does not establish reasonable cause to support his position. *213 Petitioner misunderstands these paragraphs and incorrectly applied them to his factual situation. For example, the second paragraph comports with section 446(d) in stating, generally, that a taxpayer with two separate and distinct businesses may use different methods of accounting to report income for each business. This provision does not have application to petitioners' situation, however, as Real McCoy is not a separate and distinct trade or business, and the deduction claimed by Real McCoy did not arise from a bona fide transaction.

As illustrated, the above passages do nothing to assist petitioner in demonstrating reasonable cause. Since petitioner has not raised any other arguments in his defense, we find that he has failed to satisfy his burden. Accordingly, we hold petitioners liable for the accuracy-related penalty asserted against them.

To reflect the foregoing,

Decision will be entered for respondent.