Donald L. & Evelyn Russell, Petitioner

T .C . Memo . 2008-246 UNITED STATES TAX COUR T DONALD L . AND EV LYN RUSSELL, ET AL .,' Petitioners v . COMMISSIONED OF INTERNAL REVENUE, Responden t Docket Nos . 44255, 4456-05, 4688- 5 .

Filed October 30, 2008 .

Jon J . Jensen , fo petitioners .

Jack Forsberg ,,fo* respondent .

MEMORANDUM FINDINGS OF FACT AND OPINIO N HAINES, Judge :

T ese cases are before the Court consolidated for purpo es of trial, briefing, and opinion .

Donald and'Evelyn Russoll (the Russells), Loren and Dawn Kopsen g 'Cases-of the follDwing petitioners are consolidated herewith : Loren R . and Dawn Kopseng, docket No . 4456-05 ; United Energy Corp ., docket N . 4688-05 .

D OCT 3 0 2008 (theKopsengs), and United Energy Corp . separately petitioned the Court for redetermination of the following deficiencies i n Federal income tax :

Donald L . & .Evelyn Russell, docket No . 4425-05 TYE Deficiency 12/31/1997 $128,41 4 Loren R . & Dawn Kopseng, docket No . 4456-05 TYE Deficienc y 12/31/1997 $278,340 United Energy Corp ., docket No . 4688-05 TYE Deficienc y 6/30/1998 $437,698 The issue for decision after concessions is whethe r instruments entitled "notes", "ledger debt", and "short-ter m debt" constituted "indebtedness of the S corporation to the shareholder" for purposes of determining whether petitioners Donald Russell (Mr . Russell) and Loren Kopseng (Mr . Kopseng) ha d sufficient basis under section 1366(d)(1)(B) to claim their distributive 'shares of the loss incurred by Missouri Rive r Royalty Corp . 2 2Unless otherwise indicated, all section references are to the'Internal'Revenue Code, as amended, and all Rule reference s (continued .

.

_ 3 FINDINGS OF FAC T Some of the-fact have been stipulated and are so found .

The stipulation of-fa is and the supplemental stipulation o f facts ., together with ttached exhibits, are incorporated herein by this reference . A the time the Russells and Kopsengs filed their petitions, the y resided in North Dakota ., At the tim e United Energy Corp .

EC) filed its petition, its principal pla c of business was in No th Dakota .

On May 18, 2005 , respondent sent petitioners notices of deficiency for the ye rs at issue . Petitioners filed timel y petitions with this Court .

I . Members of the UEC Group and Predecessor Entitie s A . United Ener Corp .

UEC' was incorporated under : the "law of North Dakota on-, Au .gustl 29, 1997 . At all times since its incorporation, :(cid:127)UEC has used thej ~ accrual method of accounting for tax and f-inancial .reportin g purposes and-has had a fiscal year and taxable year ending . Jun e 30 . At all times from the initial issuance of stock by UEC on September 1, 1997, - thr ugh June-30, 1998, all of .UEC' s outstanding stock was wned-by Mr . . Russell and Mr .Kopseng .

UEC timely filed Form 1120, U .S . Corporation Income Ta x Return, for its initia short taxable year beginning`September ~ 2('.

. .continued ) are to the Tax Court Rles of Practice and Procedure . Amount s are rounded to the fle a nearest dollar .

1997,' and ending June 30, 1998 . UEC filed its Form 1120 as the common,parent of a consolidated group of corporations consisting of itself, Rainbow Gas Co . (RGC)', Rainbow Energy Marketing Corp .

(REMC), Missouri River Royalty Corp (MRRC), and Energy Leasing Corp . (ELC) .

B .

Rainbow Gas Co .

Before 1997 the assets of RGC were owned by a~North Dakot a limited partnership (RGC Partnership) . As of August 29, 1997 , all of the general and limited partnership interests in RGC Partnership were owned by Mr . Russell and Mr . Kopseng . On August 29, 1997, in a transaction qualifying as a tax-free exchange under sectioni;351(a), all the assets of RGC Partnership were transferred to RGC, a newly formed North Dakota corporation, in exchange for the issuance of 375 shares of RGC stock to Mr .

Russell and 625 shares of RGC stock to Mr . Kopseng . The RGC shares issued to Mr . Russell and Mr . Kopseng constituted all of .

the outstanding shares of RGC .

C . , Rainbow Energy Marketing Corp .

REMC is a North Dakota corporation . As of September 1, 1997, REMC had 4,512,205 shares outstanding, of which 1,108,056 were owned by Mr . Russell and 2,701,149 were owned by Mr .

Kopseng .

Missouri Ri v r Royalty Corp .

MRRC is a Nort h akdta corporation which was September 7, 1984 .

all times before Septembe r was an S corporation .

Effective September 1, 1997, MRRC' s(cid:127)S corporation election ., MRRC filed a e Tax Return for an''S Corporation , inning January 1, 1997, and ending Augus t vant times before September ..l, 1997, MRR C had 30,000 .shares outstanding, of which Mr . Russell and M II . The Section 351 Transactio n On September 1, 1997, Mr . Russell received 350 shares of UE C stock and Mr . Kopsen g received 650 shares of UEC stock as part o f a transaction qualifyi g as a tax-free exchange under section 351(a) . As part of th section 351 transaction, Mr . Russell made a contribution to UEC f 375 shares of RGCstock, 1,108,056 shares of REMC stock, nd 15 ;000 shares of MRRC stock . Mr .

.- Kopseng made a contri b tion to UEC of 625 shares of RGC stock, 2,701, 149 shares of RE C stock, and 15,000 shares of MRRC stock .

UEC's audited co n olidated financial statement for the period ending-June 30 , 1998, contained the following statement respecting the section 351 transaction : T In August, 1997 United Energy Corporation (the company) exchange 1,000 shares of its common stock for 100% of the share of Rainbow Gas Company and Missouri River Royalty and 85% of the outstanding shares of Rainbow Energy Marketing Corporation . This transaction was accounted for under the requirements of interpretation 39 of Accounting Standards Board Opinion #16, whereby the acquisitions were treated as a transfer of shares between companies with common control in a manner similar to a pooling of interest . Accordingly, all assets and liabilities of the merged companies .:were recognized at historical cost and the historical financial statements of Rainbow Gas Company, Missouri River Royalty Corporation and Rainbow Energy .Marketing Corporation became a component of the historical financial statements of the company .

The audited financial statement made no reference to any assumption or contribution of liabilities being part of the section 351 transaction .

In their capacities as the incorporators and director s of UEC, Mr . Russell and Mr . Kopseng executed a Consent to Action Taken in Lieu of Organizational Meeting dated September 3, 199 7 (consent) . With respect to the section 351 transaction, th e consent stated as follows :

The directors were authorized to issue stock pursuant to the attached Resolution in the amount of 650 shares to Loren R . Kopseng in return for his contribution of shares from Rainbow Gas Company ; Missouri River Royalty Corporation, and Rainbow Energy Marketing Corporation, and has [sic] been authorized to issue 350 shares to Donald L . Russell in return for his contribution of shares from Rainbow Gas Company ; Missouri River Royalty Corporation, and Rainbow Energy Marketing Corporation .

The consent . made no reference to any assumption or contribution of liabilities being part of the section 351 transaction .

In their-capacit es as the directors'and-officers of UEC, Mr . Russell and Mr . K pseng executed a resolution dated Septembe 3, 199-7 The,resolu t on stated :

seng .has .transferred 625 shares of ny stock., 2,701,149 shares of Rainbow Corporation stock, .-and all shares of yalty Corporation stock to Unite d n . . In return for the transfer of ted Energy Corporation is hereby ue .650 .shares of United Energy- . ck to Loren R . Kopseng . ssellthas .transferred 375 .: shares of . ny stock, 1,108,056 shares of Rainbow Corporation stock, and(cid:127)all'shares o f .Loren R . Ko Rainbow Gas Comp Energy Marketing Missouri River R Energy Corporati these-shares, Un authorized to is Corporation's s t Donald L . R Rainbow Gas Comp Energy Marketing . Missouri River Royalty Corporation stock to United Energy Corporation . In return for the transfer of these shares, United Energy Corporation is hereby authorized to issue 350 shares of United Energy Corporation's sto k to Donald L . Russell .

The resolution made no reference to any assumption o r contribution of liabilities being part of the section 35 1 transaction .

III . Financial-Instruments of the UEC Grou p MRRC required cap .tal to purchase and rework oil wells .

Petitioners acquired c4pital for MRRC through a variety o f transactions .

A . The BNC Not e On or about Augus 16, 1996, BNC National Bank (BNC) lent $1 million to MRRC . MRRC used the proceeds of the loan to-pay off certain prior loans th t had been incurred to purchase and rework oil wells . In conside ation .for the loan, MRRC gave BNC a promissory note,. for $1 million (MRRC note) and entered into a loan agreement . 9 The MRRC note bore interest at the Wall Street Journal prime rate 'plus 2 percent and required 47 monthly payments of $25,55 2 and a balloon payment of all remaining principal and interest on August 16, 2000 . Mr . Russell and Mr . Kopseng cosigned the MRR C note . Throughout the life of the loan, interest on the MRRC not e was calculated using monthly compounding and an interest rate of 10 .25 percent . At all times from August 16, 1996, through January 3, 1997, the Wall Street Journal prime rate was 8 .25 percent .

As of January 3, 1997, the principal balance of the MRRC note'was $927,936 . On January 3, 1997, BNC canceled the MRRC note in consideration for (1) a $463,968 promissory note which Mr . Russell cosigned (the MRRC/DR note), and (2) a $463,96 8 promissory note which Mr . Kopseng cosigned (the MRRC/LK note) .

Mr . Russell and Mr . Kopseng also indicated that they . intended t o guarantee the MRRC/DR note and the MRRC/LK note . 3 I The MRRC/DR note and the MRRC/LK note both listed MRRC as the borrower and indicated that they were for the renewal of the MRRC note . The MRRC/DR note and the MRRC/LK note both bore interest at the Wall Street Journal prime rate plus 2 percent an d 3Both the MRRC/DR note and the MRRC/LK note state that they are ."guarantied with the personal guarantys [sic] of Donald L . Russell and Loren Kopseng dated 1/3/97 ."

required 44 monthly p yments of $12, 776 and a balloon paymen t the remaining princip 1 and interest on August 16, 2000 . Throug March 27, 1997, inter st on :both the MRRC/DR note and the MRRC/L note was calculated u ing an interest rate of 10 .25 percent .

After March 27, 1997, interest was calculated using an interest rate of 10 .50 percent Interest on both the MRRC/DR note and th MRRC/LK note was calc lated using monthly compounding . The Wal l Street Journal prime through March 26, 199 and 8 .5 percent from March 27, 1997 , through September 29 , Between January and September 3, 1997, MRRC made 8 month l .payments of $12,77 6 the MRRC/DR note and 8 monthly payments o $12,776 on the MRRC/L note . All monthly . payments on the MRRC/D P note and on the MRRC/L'K note were applied first to interest an d then'to principal .

The interest which accrued on the MRRC/DR note and on th e MRRC/LK note between J nuary 3 and September 3, 1997, was a s follows :

Interest Accrued Throug h MRRC/DR .Note .

MRRC/LK Note Tota l Sept . 1, 1997 Sept . 3, 199 7 $30,009 $30,009 $60,018 30,217 30,217 60,43 4 As of September 1(and September 3, 1997, the principa l balances of the MRRC/D note and the MRRC/LK note were a s follows :

10 - Principal Balance MRRC/DR Note MRRC/LK Note Sept . 1, 1997 Sept .,3, 1997 $389,915 $389,91,5 389,9i 5 389,915 On September 3, 1997, using a telephone transfer, MRRC paid BNC (,1) the $389,915 principal balance of the MRRC/DR note, (2) the $389,915 principal balance of the MRRC/LK note, (3) th e accrued interest of $2,042 on the MRRC/DR note, and (4) the accrued interest of $2,042 on the MRRC/LK note .

The $60,434 of interest that was accrued and paid on th e MRRC/DR note and MRRC/LK note was reported on the 1998 UEC Form 1120 as an interest expense of MRRC . None of the $60,434 was reported on Mr . Russell's 1997 Form 1040, U .S . Individual Income Tax Return, or .,Mr . Kopseng's 1997 Form 1040, either as interest income or as an interest expense .

As of September 1 and September 3, 1997, the fair market value of the MRRC/DR note was-equal to the MRRC/DR note' s principal balance of $389,915 . As of September 1, 1997, and as of September 3, 1997, the fair market value of the MRRC/LK note was equal to the MRRC/LK note's principal balance of $389,915 .

B .

The Russell and Kopseng Ledger Deb t Before April 5, 1996, Mr . Russell made a series of cas h advances to MRRC which MRRC used for working capital (the Russell ledger debt) . As of April 5, 1996, the principal balance of it these advances totaled $562,705 . In MRRC's books, the Russel l ledger debt was recorded as a liability in a ledger account e Russell" (the notes payable Russel l On April 5, 1996 MRRC issued a $562,705 note to Mr . Russe l for the Russell ledge debt (the Russell ledger debt note)" .

of September 1, 1997 , the principal balance of the Russell ledg e debt was $65,527 .

Before April 5 , 996, Mr . Kopseng made a series-of cash !advances to MRRC whic MRRC used for working capital (the Kopse n ledger debt) . As of Aril 5, 1996, the principal balance of these advances totale $611,144 . In MRRC's books, the Kopsen g ledger debt was"recor ed as a liability in a~ledger account entitled "Notes Payab e Kopseng" (the .notes'payable Kopsen g account) .

On April 5, 1996,1 MRRC issued a $ .611,144 note to Mr . Kopsen g debt ( the Kopseng ledger debt note ), . '-As of September 1,'11997 , he principal balance of the Kopseng ledge r debt was $117,438 .

The Russell; ledg e debt and the Kopseng,-ledger debt wer e demand' obligations .

terest on the Russell ledger debt and th e Kopseng ledger debt w a calculated using monthly compounding, There was - no requirem e t that interest accruing on the Russel l ledger debt and Kopse n ledger debt be paid at-least annually .

As of Septembe r 1997,,the fair-market value-of the Russell ledger debt wa equal to the Russell ledger debt's principal balance of $65,527 . Likewise, the fair market value o f the Kopseng ledger debt was equal to the Kopseng ledger debt's principal balance of $117,438 .

Respondent concedes that the Russell ledger debt and the Kopseng ledgeriidebt constituted indebtedness of MRRC to Mr .

Russell and Mr . Kopseng for purposes of section 1366(d)(1)(B) .

,C .

The REMC Ledger Debt I?

,REMC lent .,,,MRRC $57,000 on April 1, 1996, and $37, ;000 on April 11, 1'996 .1.(REMC ledger debt) . MRRC used the REMC ledger I debtj for working capital . In MRRC's books, the REMC ledger deb t was recorded as a liability in a ledger account-entitled "Notes Payable Kopseng/Russell Partnership ." The REMC ledger debt was a demand obligation . There was no requirement that interest accruing on the REMC ledger debt be paid at least annually .

A note was prepared in connection with the REMCiiledger debt (the REMC note) . The REMC note stated, in part, that "Effective April 1, 1996, Missouri River Royalty Corporation promises to pay Kopseng/Russell Partnership $94,000 .0.0 at an interest rate of the applicable Federal Rate Table ." Interest on the REMC ledger debt was in fact calculated at a rate that varied from the Wall Street Journal PrimelRate plus 1 percent to the Wall Street Journa l Prime Rate plus 2 percent . Interest on the REMC ledger debt was calculated using monthly compounding . At all times, the rates used to calculate interest on the REMC ledger debt exceeded the short-term, monthly,-clompounding Applicable Federa l Rate as the n in effect . There was no-requirement that. interest accruing o n the REMC ledger deb t paid at least annually .

As of September 1997, the principal, balance of the REM C ledger debt was $75,7 On June 30, 199 8 an adjusting journal entry to`MRRC's boo k s reclassified $22,042 f the $75,750 balance of the REMC ledger debt to the notes pay ble . Russell account and $53,708 of the balance to the notes ayable Kopseng account . The adjusting journal entry allocat d the balance of the REMC ledger debt between the notes pa y Russell and Mr . Kopse in April of 1996 .

As of September ledger debt was equal the REMC ledger debt's principal, balance`- .

of $75,750 .

D . , The Short-T e m Debt During the period between March 7, 1997 ., and . June . 16, _1997, MRRC received'a series of loans totaling $1,830,597 (short-term debt) as follows :

Date Amount Borrowe d Mar . r7, 1997 Mar . '13, 1997 Mar . 14, 1997, Apr . 2, 1997 Apr . 4, 1997 Apr . May 15, 1997 June ,3, 1997 June 16, 1997 .:29, 1997 Total $300,50 0 236,00 0 20,00 0 447,75 0 8,20 0 336,00 0 2,50 0 455,64 7 24,00 0 1,830,59 7 MRRC used the proceeds of the short-term debt for workin g capital .

.Between May 13, 1997, and August 27, 1997, MRRC repai d $629 ;000 of principal on the short-term debt as follows :

r Date Amount Repai d a May ',13, 1997 July, 3, 1997 Aug . 15, 1997 Aug . 25, 1997 Aug . 27, 1997 Total $200,00 0 165,00 0 90,00 0 200,00 0 37,00 0 692,00 0 No interest was paid on the short-term debt before September 3, 1997 .

The loans making up the short-term debt were transferred directly from'the checking account of RGC Partnership to the checking account of MRRC . The repayments were transferred directly from the checking account of MRRC to the checking account of RGC Partnership . Before August 31, 1997, the short- term debt was'recorded in MRRC's books as a liability in a ledger account entitled "Notes Payable RGC" . As of August 31, 1997, an adjusting journal- entlry to MRRC's books reclassified $569,29 8 the short-term debt to the notes payable Kopseng account an d $569,298 to the notes payable Russell account .

With respect to ach'of the nine loans comprising the short term debt, four notes were prepared : (1) One from Mr . Russell t ' RGC Partnership (Russ ll/RGC notes), (2) one from Mr . Kopseng t RGC Partnership (Kops ng/RGC notes), (3) one from MRRC to M Russell (MRRC/Russell notes), one from MRRC to Mr .

Kopseng'(MRRC/Kopseng notes) . The face_amount'of . .each note wa s half of the amount .t r nsferred from,RGC Partnership to MRRC o n the date of the respe tive transfer .

The face amounts of the Russell ./RGC notes, the Kopseng/RG C notes, the .MRRC/Russell notes, and the MRRC/Kopseng note s (collectively the shot-term notes) were,_ .se.t forth as follows :

Short-Term Deb t ate Lent Amoun t Ma rch 7, 1997 Ma rch 13, 1997 Ma rch 14, 1997 April 2, 1997 Ap it 4, 1997 Ap it 29, 1997 Ma 15`, 1997 Ju e 3, 1997 Ju e 16, 1997 otal $300,50 0 236,00 0 20,00 0 447,75 0 8,20 0 336, 00 0 2,50 0 455,64 7 24,00 0 1,830,597 Face Amount of Shareholder/RGC Notes Russell to RGC Kopseng to RG C $150,250 118,000 10,000 223,875 4,100 168,000 1,250 227,823 12,000 915,298 .

$150,25 0 118,00 0 10,00 0 223,,87 5 4,10 0 168,00 0 1,25 0 227,82 3 12,00 0 915,29 8 Face Amount of MRRC/Shareholder Notes MRRC to Russell MRRC to Kopsen g $150,250 118,000 10,000 223,875 4,100 168,000 1,250 227,823 12,000 915,298 $150,25 0 118,00 0 10,00 0 223,87 5 4,10 0 168,00 0 1,25 0 227,82 3 12,00 0 915,29 8 Each of the short-term notes bore an "effective" date which was identical to the date on which the corresponding . loan was made to MMRC . Both Mr . Kopseng and Mr . Russell signed each of the short-term notes, either in their individual capacities or on behalf of RGC or MMRC, but none of their signatures were dated .

The'short-term debt was a demand obligation .

Each short-term note stated that it bore interest at "an interest rate of the applicable Federal Rate Table ." However, interest on the short-term debt was calculated at a rate that varied from the Wall Street Journal Prime Rate plus 1 percent to the . Wall Street Journal Prime Rate plus .2 percent .

the short-term debt was calculated using monthly compounding .

all times, the rates sed to calculate interest on the short-term debt,exceeded the .sho t-term, monthly-compounding Applicable Federal Rate as then (cid:127)n effect .: ., There was .no requirement that interest accruing on he short-term debt be paid at least annually .

As of";.September , 1997, and Sept .ember .3,'1997, th e principal balance of, and th e accrued interest`on, the short-ter m debt was as follows :

Dat e Interest ' Principa l Sept . 1, 1997 Sept . 3, 199 7 $61,923 $1,1 318,597 62,578 1,138,59 7 On September 3, 1997, the $1,138,597 principal balance o f the short-term debt, along with accrued interest thereon o f $62,578 , was paid by. using a $1 ,201,17 .5 cashier ' s check from MRRCI ' to RGC . The $1,201,175 . . payment was reflected in MRRC's books b y (1) debiting the notes payable Russell account for $569,298, (2) debiting the notes pay ble Kopseng .account for $569,298, and (3 ) debiting the loan inte est account for $62,578 with the memo notation "Interest pai to Kopseng & Russell for Note ." The $1,201,175 payment was reflected in RGC's books by (1) creditin g the "Notes Payable Don Russell" ledger account for $569,298, (2) crediting the "Notes P yable Loren Kopseng" ledger account for 18 - $569,298, and (3) crediting the interest income account for $62,578 with the memo notation "Interest on Note Rec . from MRRC ."

.The $62,578 of accrued interest on the short-term debt wa s reported on the, 1998 .UEC Form 1120 as an interest expense of MRRC and interest income of RGC . None of the $62,578 was reported on Mr . Russell's 1997 Form 1040 or Mr . Kopseng's 1997 Form 1040, either as interest income or interest expense .

As of September 1, 1997, and as of September 3, 1997, the fair market value of the short-term debt was equal to the short- term debt's principal balance of $1,138,597 .

The MRRC note, the MRRC/DR note, the MRRC/LK note, the Russell ledger debt, the Kopseng ledger debt, the REMC ledger debt, and the short-term debt were not "publicly offered" withi n the meaning of that term as used in section 1273(b)(1), nor wer e they property of the type described in section 1273(b)(3) .

IV . ' Russell and Kopseng's Basis . in Indebtedness andi' .MRRC Stock As of the beginning of MRRC's short taxable year ending August 31, 1997, Mr . Russell's basis in his MRRC stock was $150,151, and Mr . Kopseng's basis in his MRRC stock was zero .

The MRRC 1997 Form 1120S reported an ordinary loss o f $1,117, 540, interest income of $250, and dividend income of $208 .

Consistent with the MRRC 1997 Form 1120S , the following items from MRRC ' s taxable year ended August 31 , 1997, were reported on Mr . Russell ' s 1997 return -and on Mr . Kopseng ' s 1997 return .

Item . Amount Ordi Inte Div i ary loss est income end income .

$558,77 0 12 5 10 4 As of the .end of MRRC ' s taxable year ended August 31, 1997 :

(1) Mr . Russell's-bas s in the Russell ledger debt was $65,52 7 less the amount bywh ch his basis in the Russell ledger°debt wa o properly, reduced unde section 1367(b)(2) on account of items o f MRRC for its-taxabl e ear ending August 31, ,1997, and (2) Mr .

, Kopseng ' s -basis ` in thi Kopseng ledger debt was $117,438 less th e amount by which his b sis in the Kopsehg ledger debt was properl y reduced under section 1367(b)(2) on`account of items of MRRC fo r its taxable year endi g August 31, 1997 .