FUNDS BORROWED FROM CO-SHAREHOLDER AND LOANED TO S CORPORATION ARE NOT AT RISK.

                       UNITED STATES TAX COURT

[1] WELLS, JUDGE: Respondent determined deficiencies in petitioners' income taxes of $60,371, $14,884, $6,875, and $20,173 for their 1988, 1991, 1992, and 1993 taxable years respectively, and additions to tax pursuant to section 6662 ¹ of $2,977, $1,375, and $4,035 for their 1991, 1992, and 1993 taxable years respectively.

[2] In the instant case, after concessions, we must decide the following issues: (1) Whether petitioner Larry Van Wyk is at risk with respect to a loan he made to an S corporation in which he owns 50 percent of the stock, where the source of the funds constituting the loan is the other 50-percent shareholder and that shareholder's wife; and (2) whether petitioners are liable for substantial understatement penalties under section 6662.

BACKGROUND

[3] The parties submitted the instant case fully stipulated pursuant to Rule 122. The facts stipulated by the parties are incorporated herein by reference and are found as facts in the instant case. When they filed their petition, petitioners resided in Monroe, Iowa.

[4] During the years in issue, petitioner Larry Van Wyk (petitioner) and his brother-in-law, Keith Roorda, each owned 50 percent of the stock of West View of Monroe, Iowa, Inc. (West View), an S corporation engaged in the business of farming.

[5] On December 24, 1991, petitioners borrowed $700,000 from Keith Roorda and his wife, Linda Roorda. To evidence their debt to Keith and Linda Roorda (the Roordas), petitioners executed a promissory note bearing interest at 10.5 percent per annum. The note was unsecured. Also, on December 24, 1991, petitioners transferred $700,000 to West View. Of that amount, $253,583 retired debts petitioners owed to West View with the remaining $444,417 constituting indebtedness owed by West View to petitioners (the loan).

[6] On their tax returns for 1988 through 1993, petitioners reported one-half of the profits and losses from West View. Respondent determined that petitioners' income should be increased in the amounts of $252,503, $438,811, $115,230, and $165,277 for the taxable years 1988, 1991, 1992, and 1993, respectively, on account of the disallowance of petitioners' deductions of West View's losses for those years. Additionally, respondent determined that, for 1993, petitioners' income should be increased by $93,239, on account of the disallowance of petitioners' deduction of West View's loss for the 1991 taxable year, which petitioners carried forward to 1993. Finally, respondent determined that petitioners are liable for a substantial understatement penalty pursuant to section 6662 for taxable years 1991, 1992, and 1993.

DISCUSSION

[7] We have been asked to resolve whether petitioner is at risk with respect to the loan. ² Petitioners argue that petitioner should be considered at risk with respect to the loan pursuant to section 465(b)(1)(A). Additionally, petitioners argue that petitioner should be considered to be at risk with respect to the loan pursuant to section 465(b)(1)(B). Specifically, petitioners maintain that section 465(b)(3)(B)(ii) applies to the instant case.

[8] The relevant portions of section 465 provide as follows:

     SEC. 465. DEDUCTIONS LIMITED TO AMOUNT AT RISK.

[9] Petitioners' first argument is that petitioner should be considered at risk with respect to the loan pursuant to section 465(b)(1)(A). Petitioners contend that section 1.465-10(d), Example, Proposed Income Tax Regs., 44 Fed. Reg. 32240 (June 5, 1979) "clearly illustrates this principle." The example provides as follows:

     A is the single shareholder in X, an electing small business

[10] Petitioners additionally argue that section 1.465-10(c), Proposed Income Tax Regs., 44 Fed. Reg. 32240 (June 5, 1979), supports their argument that petitioner should be considered at risk with respect to the loan. The proposed regulation provides that "The amount at risk of a shareholder of an electing small business corporation * * * shall be adjusted to reflect any increase or decrease in the adjusted basis of any indebtedness of the corporation to the shareholder". Id. Petitioners' reliance on section 1.465- 10(c), Proposed Income Tax Regs., supra, is flawed for the same reason we reject petitioners' argument concerning section 1.465- 10(d), Example, Proposed Income Tax Regs., supra, i.e., the proposed regulation just does not contemplate the source of the funds, an issue governed by section 465(b)(1)(B) and its related provisions.

[11] As to what is meant by "money * * * contributed by the taxpayer to the activity" within the meaning of section 465(b)(1)(A), the proposed regulations provide: "A taxpayer's amount at risk in an activity shall be increased by the amount of personal funds the taxpayer contributes to the activity." Sec. 1.465-22(a), Proposed Income Tax Regs., 44 Fed. Reg. 32241 (June 5, 1979). According to the proposed regulations, "personal funds" of a taxpayer are those owned by the taxpayer and are not those acquired through borrowing. Sec. 1.465-9(f), Proposed Income Tax Regs., 44 Fed. Reg. 32240 (June 5, 1979).

[12] Petitioners acknowledge the proposed regulations regarding personal funds but note that they are over 19 years old and still in proposed form. Petitioners also note that the personal funds requirement is not mentioned in either the statute or the legislative history. Accordingly, petitioners claim that the proposed regulations carry little weight as to the personal funds requirement. We think it anomalous that petitioners embrace the proposed regulations as support for their argument, yet argue that the proposed regulations do not apply when they present contrary authority. Nonetheless, proposed regulations are given no greater weight than a position advanced by the Commissioner on brief. See, e.g., F.W. Woolworth Co. v. Commissioner, 54 T.C. 1233, 1265-1266 (1970). Yet proposed regulations can be useful as guidelines where they closely follow the legislative history of the act. See Estate of Wallace v. Commissioner, 95 T.C. 525, 547 (1990), affd. 965 F.2d 1038 (11th Cir. 1992). We have previously cited the section 465 proposed regulations for that purpose. See Melvin v. Commissioner, 88 T.C. 63 (1987), affd. 894 F.2d 1072 (9th Cir. 1990).

[13] To read section 465(b)(1)(A) as petitioners suggest would be inconsistent with section 465(b)(1)(B). Accordingly, we conclude that Congress did not intend such a result and that such a construction of the statute would be inappropriate. See, e.g., Weinberger v. Hynson, Westcott & Dunning, Inc., 412 U.S. 609, 633-634 (1973) (interpreting a statute in such a manner "offends the well- settled rule of statutory construction that all parts of a statute, if at all possible, are to be given effect"); In re Windsor on the River Associates, 7 F.3d 127, 130 (8th Cir. 1993); Bokum v. Commissioner, 94 T.C. 126, 154 (1990), affd. 992 F.2d 1132 (11th Cir. 1993).

[14] Respondent also points to statements by the Staff of the Joint Committee on Taxation as an explanation of how Congress intended section 465(b)(1) to operate when there is an overlap in coverage between section 465(b)(1)(A) and (B):

     The amounts borrowed by the taxpayer and then contributed to the

[15] Petitioners additionally contend that the loan should be considered at risk pursuant to section 465(b)(1)(B). Petitioners argue that the loan is not subject to the general prohibition of section 465(b)(3)(A) against borrowing from parties with an interest in the activity because of the exception provided by section 465(b)(3)(B)(ii). Petitioners argue:

     Van Wyk loaned funds to West View, thus fulfilling the first

[16] We agree with respondent that the proper interpretation is that section 465(b)(3)(B)(ii) applies only to allow at-risk status for a corporate borrower, not to an individual shareholder merely because he made the loan in question to his corporation. Section 465(b)(1)(B) and (2) speaks to amounts borrowed by a taxpayer -- in the instant case, the reference to a taxpayer is to petitioner. Section 465(b)(3)(A) prohibits at-risk treatment for those amounts, i.e., the amounts borrowed by the taxpayer (in the instant case petitioner), if those amounts are borrowed from a person with an interest in the activity or from a person related to such a person. Section 465(b)(3)(B)(i) excepts those borrowed amounts, i.e., allows at-risk treatment, where the only interest in the activity possessed by the lender (the person from whom the taxpayer borrowed the money) is a creditor's interest. That exception does not apply to the instant case because Keith Roorda's interest in the activity is an equity interest, which is a prohibited interest. ³ Moreover, Linda Roorda, as the wife of Keith Roorda, is a "related person to a person with an interest in the activity" within the meaning of section 465(b)(3)(A). ⁴ As we read section 465(b)(3)(B)(ii), it excepts borrowed amounts only where the borrower that is claiming to be at risk on those amounts is a corporation. ⁵ In the instant case, because the taxpayer claiming to be at risk for the borrowed amounts is an individual, section 465(b)(3)(B)(ii) does not apply.

[17] The House report accompanying the enactment of the Deficit Reduction Act of 1984 (DEFRA), Pub. L. 98-369, sec. 432(c), 98 Stat. 494, 814, the act which added section 465(b)(3)(B)(ii) to the Code, supports our reading of section 465. The House report states:

     Borrowing from related parties

Petitioners contend that if Congress intended the exception of section 465(b)(3)(B)(ii) to apply only to corporations, i.e., only at the corporate level, it would have expressly provided that the exception applied only for purposes of calculating corporate-level at risk amounts. Petitioners further contend that, because there is no express language in section 465(b)(3)(B)(ii) limiting its application only to corporations, the statute should be construed to afford them relief. Indeed, if the statute contained such language, our task would have been simpler. The failure of the statute to contain such language, however, does not persuade us that our interpretation is incorrect.

[18] Additionally, we note that 2 years after section 465(a)(1) was amended to eliminate the at-risk limitations for S corporations, ⁷ section 465(b)(3)(B)(ii) was added to the Code by DEFRA section 432(c). The logical inference, therefore, is that, because the at- risk status of an S corporation is no longer relevant, where section 465(b)(3)(B)(ii) addresses the at-risk status of a corporation borrowing from its shareholders, the statute must refer only to C corporations that are subject to section 465.

[19] For the reasons stated above, we simply are not persuaded by petitioners' arguments or their interpretation of the statute. Accordingly, we hold that, because the source of the funds constituting the loan is not excepted by section 465(b)(3)(b)(ii), petitioner, pursuant to section 465(b)(3)(A), is not considered to be at risk with respect to the loan.

SECTION 6662(a)

[20] The final issue is whether petitioners are liable for a penalty under section 6662. Section 6662(a) imposes a 20-percent penalty on the portion of an underpayment of tax that is attributable to, inter alia, any substantial understatement of income tax. A substantial understatement of tax is defined as the amount which exceeds the greater of 10 percent of the tax required to be shown on the return for the taxable year or $5,000. See sec. 6662(d)(1)(A). An understatement is reduced to the extent it is: (1) Based upon substantial authority; (2) adequately disclosed in the tax return or in a statement attached to the return and there was a reasonable basis for the treatment of the item. See sec. 6662(d)(2)(B). Petitioners must establish error in respondent's determination that they are liable for the penalty provided by section 6662(a). See Rule 142(a).

[21] The section 6662 penalty does not apply to any portion of an underpayment where it is shown that there was reasonable cause and that the taxpayer acted in good faith. Sec. 6664(c)(1). The decision as to whether the taxpayer acted with reasonable cause and in good faith depends upon all pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Under the circumstances of the instant case, we believe that the complexity of section 465, and the lack of express guidance in the regulations, led petitioners to an honest mistake of law for which it is inappropriate to penalize them. Accordingly, we do not sustain the section 6662 determination by respondent.

[22] To reflect the foregoing,

[23] Decision will be entered under Rule 155.

² The parties have stipulated the losses which petitioners will be entitled to deduct in accordance with our decision as to whether petitioner is at risk with respect the loan. Accordingly, other than the penalty issue discussed below, this is the only issue which we are called upon to decide. The parties also agree that the at-risk determination is to be made at the shareholder level and not at the S corporation level.

³ In Jackson v. Commissioner, 86 T.C. 492, 529 (1986), affd. 864 F.2d 1521 (10th Cir. 1989), we held that a prohibited interest is a capital interest in the activity or an interest in the net profits of the activity. We have applied the holding in Jackson in later cases. See Levy v. Commissioner, 91 T.C. 838, 868 (1988); Larsen v. Commissioner, 89 T.C. 1229, 1270 (1987), affd. in part and revd. on another issue sub nom. Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990); Bennion v. Commissioner, 88 T.C. 684, 698 (1987). In these cases, we defined a capital interest as an interest in the assets of the activity which is distributable to the owner of the capital interest upon liquidation of the activity.

⁴ "Related person" includes a spouse. See secs. 465(b)(3)(C), 267(b)(1) and (c)(4).

⁵ Put more technically, the following analysis was set forth in respondent's brief:

     "Taxpayer" in * * * paragraph 465(b)(1) is the antecedent to

     The Act further provides that, except to the extent provided in