Levine v. Commissioner , 31 T.C. 1121 ( 1959 )

Mac Levine and Anne E. Levine, Petitioners, v. Commissioner of Internal Revenue, Respondent

Levine v. Commissioner

Docket No. 57760

United States Tax Court

31 T.C. 1121; 1959 U.S. Tax Ct. LEXIS 230;

February 27, 1959, Filed

---

Decision will be entered under Rule 50.

Petitioner's loans to corporation, and unrecouped guaranty payment, later transferred for nominal amount, being wholly uncollectible and proximately related to petitioner's individual business, held, to constitute business bad debts deductible as such rather than merely as capital losses.

George B. Lourie, Esq., and Arnold R. Cutler, Esq., for the petitioners.

Frank V. Moran, Jr., Esq., for the respondent.

Opper, Judge.

---

OPPER

Respondent determined deficiencies in petitioners' income tax for the years 1947, 1948, 1949, and 1950 in the respective amounts of $ 14,704.93, $ 1,178.02, $ 927.54, and $ 1,827.60. The only item in controversy is a part of the deficiency determination for 1947. The issues remaining are: (1) Whether petitioner Mac Levine's claims against his partly owned corporation became worthless in the tax year and whether they constituted a business or nonbusiness bad debt; or whether his transfer of such claims to a purchaser of the corporation constituted the sale or exchange of capital assets; and (2) whether the loss sustained by petitioner Mac Levine upon payment as a guarantor of the corporation's obligation constituted a business or nonbusiness bad debt.

FINDINGS OF FACT.

Certain facts were orally stipulated and are hereby found.

Mac Levine, hereafter called petitioner, and Anne Levine, husband and wife, filed their joint Federal income tax return for the calendar year 1947 on an accrual method of accounting with the collector of internal revenue for the district of Massachusetts.

From 1945 through 1947, petitioner engaged in the business of manufacturing springs for furniture and bedding. He conducted this business as a sole proprietor under the name of Webster Spring Company.

Sometime in 1945, petitioner determined that his customers needed fabrics in addition to springs. The market for fabrics was tight with the result that it was difficult to sell springs unless petitioner's customers had a fabric source. Petitioner felt that the establishment of a plant to produce fabrics which could be sold to petitioner's spring customers would increase the sales of his spring business. On December 19, 1945, petitioner and his brothers organized General Textile Mills, Inc., hereafter called General, which manufactured and sold fabrics for upholstering furniture. Petitioner's hopes to increase the sales of his spring business by the operation of General were realized and he received spring business because General was able to supply textile fabrics also.

In 1946, one of petitioner's other brothers formed a sales organization on the west coast with the purpose of obtaining upholstery fabrics and springs to sell. In 1946, petitioner sold $ 85,000 to $ 90,000 of its total volume of $ 500,000 to this west coast organization. Prior to this time he had had no west coast customers. The brother was also able to purchase fabrics from General.

Petitioner and his brothers invested $ 30,000 in the capital stock of General and unrelated parties contributed machinery valued at approximately $ 5,000. At a later date petitioner and one of his brothers invested in the preferred stock of General.

During 1946 and 1947, General needed money and petitioner made the following loans to it:

Date	Amount
June 17, 1946	$ 5,000
July 1, 1946	5,000
Mar. 10, 1947	1,200
Mar. 24, 1947	1,000
Apr. 3, 1947	1,000
Apr. 9, 1947	1,000
Apr. 11, 1947	1,000
Total	15,200

These loans were evidenced by promissory notes payable in 3 months or less. General did not repay petitioner.

In 1946, Paul Barrow, a customer of petitioner's spring business, loaned $ 4,000 to General which petitioner and his brother guaranteed. General repaid $ 1,400 on this loan, and in May 1947, petitioner and his brother each paid $ 1,300. General did not repay petitioner.

General borrowed money from Mill Factors Corporation, hereafter called Factor. To secure the notes so given, General assigned its accounts receivable and mortgaged its inventory and machinery to Factor.

Sometime in April 1947, Factor took over control of General and informed petitioner that his "interests were practically wiped out." After this petitioner exercised no management, authority, or control over General.

Sometime in May 1947, petitioner's accountant studied a balance sheet of General as of April 30, 1947. He estimated the value of the assets and the nature of the liabilities, determined that the secured claims and the priority claims exceeded the estimated values of the assets, and so reported to petitioner. Petitioner thereupon instructed his bookkeeper to write off as uncollectible the loans to General in June 1947, the next writeoff date in the course of his business. The loans were written off as bad debts in June 1947.

In September 1947, Factor sold its General notes and obligations to Quaker Pile Fabric Corporation, hereafter called Quaker. In October 1947, a stockholder of General informed petitioner that Quaker was interested in acquiring General. Petitioner, at the request of this stockholder, attended a conference on October 6, 1947, in Providence, Rhode Island.

At this conference, in which petitioner took no active part, Quaker offered $ 500 as a "token" settlement of all claims against General and offered petitioner a minority interest for his General stock and a sum of money for an assignment of his claims against General. There were no negotiations as to the amount to be paid for the assignment of claims. Petitioner transferred to Quaker, in consideration of $ 362, all his claims against General under the promissory notes. The parties signed the documents on October 6, 1947. Petitioner retained possession of the promissory notes.

On October 6, 1947, General was reorganized and its name was changed to Providence Pile Fabric Corporation, hereafter called Providence. Quaker surrendered and canceled the claims against Providence acquired from Factor, petitioner, and other creditors in exchange for capital stock of Providence.

Petitioner deducted on Schedule C of his return for 1947, $ 16,138 as a "Loss on Notes Receivable." This figure constitutes the result of adding $ 15,200 of advances and $ 1,300 payment on guaranty, making a total of $ 16,500, and deducting therefrom the $ 362 received from Quaker. Respondent disallowed the deduction and determined that $ 14,838 represented a long-term capital loss and $ 1,300 represented a nonbusiness bad debt loss.

Petitioner's claims against General became worthless and were charged off in the spring of 1947.

Losses sustained from the worthlessness of the loans and unrecouped payment on petitioner's guaranty were proximately related to petitioner's trade or business.

OPINION.

Respondent determined that petitioner's loss when he was required to make good on a guaranty was a "nonbusiness bad debt" -- a result possible only if the primary debtor was unable to reimburse him. At the same time, respondent has determined that other debts owed to petitioner by the primary debtor did not become worthless during the taxable year.

Without regard to this apparent inconsistency, the record seems to us to show prima facie that all of the indebtedness became worthless early in the tax year, and that any burden of going forward was shifted to respondent. The business of the debtor was taken over at that time by a factoring concern which was the debtor's principal secured creditor. Petitioner was informed by it that his interest was wiped out, but in order to confirm the information, his accountant examined the balance sheet and concluded that the secured and priority liabilities exceeded the assets. Thereupon petitioner instructed his bookkeeper to charge off the accounts.

It is true that the testimony of petitioner and his accountant is the source of these statements. See Union Trust Co., Executor, 9 B.T.A. 1374">9 B.T.A. 1374. But in the absence of impeachment or contradiction, their interest does not require complete rejection of their evidence. Jay A. Williams, 28 T.C. 1000">28 T.C. 1000; Arthur N. Blum, 11 T.C. 101">11 T.C. 101, affd. (C.A. 3) 183 F.2d 281">183 F. 2d 281.

Later in the same year petitioner received a token payment from a prospective purchaser of the debtor's business. This development lacks significance, because the payment then of a nominal nuisance value fails to negate the actual worthlessness of the claims, and if anything, in fact demonstrates it. See De Loss v. Commissioner, (C.A. 2) 28 F.2d 803">28 F. 2d 803, affirming 6 B.T.A. 784">6 B.T.A. 784, certiorari denied 279 U.S. 840">279 U.S. 840. Subsequent events might give rise to offsetting income, or, which would be the same thing, cast doubt upon the correctness of the earlier chargeoff. See Paterson v. United States, (S.D. Ala.) 122 F. Supp. 770">122 F. Supp. 770. But this is not that situation, nor is it such a case as Maurice Levy, 46 B.T.A. 423">46 B.T.A. 423, affd. (C.A. 2) 131 F.2d 544">131 F. 2d 544, certiorari denied 318 U.S. 780">318 U.S. 780, where "there was, within the taxable year, before the actual chargeoff of the indebtedness, the sale of the account."

When a debt is "written off" it is not thereby disposed of. It remains an asset in the hands of the obligee. The precedents are replete with instances of subsequent recoveries on obligations previously treated as totally or partially worthless. E.g., Citizens State Bank, 46 B.T.A. 964">46 B.T.A. 964. In such a situation the debt remains the property of its owner, its ultimate fate to remain open for future developments. If there is a total or partial recovery, this will constitute income, at least to the extent of any prior tax benefit. Excelsior Printing Co., 16 B.T.A. 886">16 B.T.A. 886. If it is sold, whether or not as a capital asset, the result is an income adjustment, with the item given a basis of zero or more, depending on the previous treatment. Merchants National Bank of Mobile, 14 T.C. 1375">14 T.C. 1375, affd. (C.A. 5) 199 F.2d 657">199 F. 2d 657. Cf. Conrad H. Hilton, 13 T.C. 623">13 T.C. 623. But except for John F. B. Mitchell, 13 T.C. 368">13 T.C. 368, it has never been assumed that a subsequent sale or exchange destroys the effect of a previous writeoff on the ground that the holder no longer owns the asset at the year's end.

To be sure, if a debt is written off in whole or in part, subsequent developments in the same tax year may throw light on the correctness of such action. In that case it is of little consequence whether we view the original writeoff as correct, subject to the adjustment, or as a single process to be treated as a year-end entry. This would be true whether a wholly worthless debt turned out to be partially collectible, or even presumably where a debt originally considered worthless only in part developed as entirely uncollectible. A sale might, of course, indicate the error of regarding a debt as totally worthless. But this would be merely evidentiary and not substantive.

We conclude that respondent erred in dignifying the later transfer for a nominal amount as the sale of a capital asset, at least to any extent beyond a zero basis; but that, on the contrary, the indebtedness had already become worthless and was properly treated as such.

A possible impediment to these conclusions is certain language contained in John F. B. Mitchell, supra at 372, ^{Mitchell v. Commissioner, (C.A. 2) 187 F. 2d 706, 707, the Court of Appeals saying: "We would, therefore, sustain the Tax Court, were there no more to this case." It had already, however, used the following language:}

The Tax Court made this ruling: Where a taxpayer partially charges off a note and later in the same taxable year sells the note at a price equal to the reduced value remaining after the charge-off, the taxpayer may not deduct the amount of the charge-off under 26 U.S.C. § 23 (k) but is entitled solely to a capital loss deduction on the sale. We do not agree with this blanket generalization. The situation is not the equivalent of a sale followed in the same year by a partial charge-off. For in such a case, after the sale, the taxpayer owns no debt which he can charge off, whereas, when the sale is the later event, there is no reason why the charge-off, if independent of the sale, should not be deductible. The fact that both transactions occur in the same year is irrelevant; the requirement of accounting for income tax purposes, on an annual basis is, we think, immaterial in this context.

But the result is different if the taxpayer has arranged for the sale before he makes the charge-off; for then, in reality, he is charging off a debt he no longer owns. * * *

The case was remanded for consideration of a contention not advanced below. The principles stated by the Court of Appeals have apparently since been accepted by the Tax Court. Von Hoffman Corp. v. Commissioner, (C.A. 8) 253 F. 2d 828, 831, affirming T.C. Memo. 1957-127. Since the Mitchell case is thus distinguishable on its facts, and the expression of the views of the Court of Appeals is contrary to the dictum to which we have referred, we regard the conclusion now being reached as correct in its application to the present facts.

While a much closer question, we conclude also that the indebtedness, including the guaranty, was a business rather than a nonbusiness bad debt. Petitioner, being a sole proprietor, does not run afoul of such cases as Burnet v. Clark, 287 U.S. 410">287 U.S. 410; Charles G. Berwind, 20 T.C. 808">20 T.C. 808, affirmed per curiam (C.A. 3) 211 F.2d 575">211 F. 2d 575, that a business is not that of the taxpayer but of a separate corporation. Factual patterns are always different but we think the present circumstances are sufficiently similar to Estate of Lawrence M. Weil, 29 T.C. 366">29 T.C. 366; J. T. Dorminey, 26 T.C. 940">26 T.C. 940, to require the same result. Here again the facts are based on petitioner's testimony which respondent characterizes as "biased and uncorroborated," but we are not prepared to disregard it entirely as we would have to do to reach respondent's result. Because of uncontested items,

Decision will be entered under Rule 50.

---

Footnotes

• 1. "True, the charge-offs were made earlier in the year, but their effectiveness for deduction purposes must be judged at the close of 1944, at which time they had lost their significance, due to the disposal of the obligations to which they were related."↩