disputed issues which are material and accordingly resolve the instant motions solely on the questions of law.
Section 166(a) of the Internal Revenue Code (Code), 26 U.S.C. § 166(a), provides that, in computing taxable income, a taxpayer may take a deduction for any debt owed to him that becomes worthless (bad debt) within the taxable year. The starting point for any consideration of this deduction is whether the investment in question was a debt or not. "A bona fide debt is 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. A gift or contribution to capital shall not be considered a debt for purposes of section 166." Treas. Reg. § 1.166-1(c). Although plaintiff does not address this question, it must be the initial inquiry.
In this regard, Section 385 of the Code sets forth a number of criteria that the Secretary of the Treasury may apply in determining whether any advance is to be considered within a debtor-creditor relationship or a corporation-shareholder relationship.
Interestingly enough, the Secretary has yet to prescribe regulations under this section, although it was originally enacted on December 30, 1969. Consequently, exactly which standard to apply has been of some difficulty and, as I pointed out in Scriptomatic, Inc. v. United States, 397 F. Supp. 753 (E.D. Pa. 1975), aff'd 555 F.2d 364 (3d Cir. 1977), the "result has been a plethora of ambiguous and contradictory opinions." Id. at 758. For instance, a list of sixteen factors was identified by the Third Circuit in Fin Hay Realty Company v. United States, 398 F.2d 694, 696 (3d Cir. 1968), but where not all the criteria are pertinent, an analysis of a lesser number will suffice. Joseph Lupowitz Sons, Inc. v. Commissioner of Internal Revenue, 497 F.2d 862, 865-66 (3d Cir. 1974); Trans-Atlantic Co. v. Commissioner of Internal Revenue, 469 F.2d 1189, 1192-93 (3d Cir. 1972).
However, as Judge Reedman pointed out in Fin Hay, no single criterion or group of criteria is decisive in this determination and the factors should only be used as aids in analyzing the realities of the transaction, i.e., whether it is actually a contribution to capital or a true loan. 398 F.2d at 697. In any case, the burden is on the taxpayer to demonstrate that the advances were indeed indebtedness. P. M. Finance Corp. v. Commissioner of Internal Revenue, 302 F.2d 786, 789 (3d Cir. 1962).
III. Debt or Equity
Three primary facets of the advances must be considered in determining whether debt or equity was created: (1) the form of the instruments; (2) the intent of the parties, and (3) the objective economic reality as it relates to the risks taken by investors. This analysis can only lead to the conclusion that the advances here were capital contributions.
First and foremost in this case is the absence of a written document which would create in taxpayer an unconditional right to demand payment. There are no papers or other formal indicia evidencing the arrangement, with the possible exception of a February 7, 1967, note from Yank to Fischer.
See Fin Hay, supra (criteria 7); Lupowitz, supra (criteria e). Thus, there was no provision for interest, no enforceable obligation on Yank's part to repay the funds advanced, no maturity date, no provision for prepayment by the corporation, Fin Hay, supra (criteria 10, 13, and 14); Lupowitz, supra (criterind g), and no provision for superiority of lien on Yank's assets.
The absence of an unconditional right to demand payment is practically conclusive that an advance is an equity investment. Scriptomatic, supra, 397 F. Supp. at 759; Plumb, The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L. Rev. 369, 413 (1971).
Normally, in a corporation which has a number of shareholders, parties will deal at arm's-length and the form of the resulting transaction will mirror its substance. But where a closely-held corporation is involved and the same persons sit at both sides of the bargaining table, form will not always correspond to the nature of the transaction, for the parties may create whatever appearance may be of tax benefit to them despite the economic reality of the advance. "This is particularly so where a shareholder can have the funds he advances to a corporation treated as corporate obligations instead of contributions to capital without affecting his proportionate equity interest." Fin Hay, supra, 398 F.2d at 697. Thus, conclusory declarations that the parties intended to create debts should carry little weight. Neither can the court read the parties' minds; rather, intent can only be ascertained from objective factors. In considering all of the objective factors, I can draw only one inference: these advances were intended to be equity investments.
First, it is clear from the previous discussion that the parties failed to follow any formality with regard to the advances. There was no corporate action authorizing the "borrowing,"
taxpayer did not take any security as a result of his advances, and there was no provision made for a sinking fund or corporate reserve to effect repayment. Second, persuasive evidence of an initial intention to repay purported debt is the fact that all payments are actually met on time. Harlan v. United States, 409 F.2d 904, 909 (5th Cir. 1969); Plumb, supra at 490-91. Here, if the parties did intend taxpayer's advances to be debt and did intend to abide by the same conditions afforded taxpayer's lenders, then it is evident that such payments were not effected timely. In fact, only four payments totalling $37,500. in principal were ever made to taxpayer to allow him to repay the advances of Dr. Ulansey and Mr. Cohen. In short, Fischer failed to act like a creditor. See Wood Preserving Corp. of Baltimore v. United States, 347 F.2d 117, 119 (4th Cir. 1965). Instead, by tolerating prolonged defaults in the payment of principal, he evidenced an attitude of placing his shareholder interests ahead of his creditor interests in order to advance the needs of the corporation. I conclude that since the parties treated these advances as equity investments are normally treated, I must consider them to be equity.
C. Economic Reality
The final consideration is the economic reality of the transactions. "Since Congress has chosen to give different tax consequences to debt and to stock, it 'would do violence to the congressional policy' to treat as debt a purported loan that 'is so risky that it can properly be regarded only as venture capital.'" Plumb, supra at 503, quoting Gilbert v. Commissioner of Internal Revenue, 248 F.2d 399, 407 (2d Cir. 1957). Several tests have been utilized as aids in this analysis.
1. The Debt-Equity Ratio Test
One of the criteria mentioned in Fin Hay and Lupowitz and now given express significance by Congress in Section 385 of the Code, see note 10, supra, is the "thinness" of the corporation's capital structure in relation to its debt. In Lupowitz, 497 F.2d at 866, the court cited with approval Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969), wherein it was held that:
"thin capitalization is very strong evidence" of a capital contribution where: "(1) the debt to equity ratio was high to start with, (2) the parties understood that it would likely go higher, and (3) substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations." United States v. Henderson, 375 F.2d 36, 40 (5th Cir. 1967).