Summary
In Stamos v. Commissioner, 22 T.C. 885, 888 (1954), we held that a taxpayer's legal fees incurred for the sole purpose of obtaining release of a loan guaranty qualified as deductible losses on a transaction entered into for profit.
Summary of this case from Nathel v. CommissionerOpinion
Docket No. 39787.
1954-07-14
PETER STAMOS AND CATHERINE C. STAMOS, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Herbert M. Matties, Esq. , for the petitioners. S. Jarvin Levison, Esq. , for the respondent.
1. Petitioner was an organizer, stockholder, officer, and director of Paramount Exposition Shows, Inc. (referred to as the corporation). He guaranteed notes given by the corporation to purchase a carnival which it had been organized to run. The corporation became insolvent and discontinued business in December 1947. Petitioner in 1948 paid $3,000 in settlement of his guaranty. The corporation was not dissolved until December 15, 1950. Held, upon payment of the $3,000 by petitioner a debt arose in his favor from the corporation despite the fact that such debt was worthless when it arose. Consequently, petitioner may only deduct the $3,000 as a nonbusiness bad debt under section 23(k)(4) of the Internal Revenue Code, rather than as a loss under section 23(e)(2).
2. Held, legal expense paid by petitioner in connection with the settlement of his guarantor's liability is deductible as a nonbusiness loss under section 23(e)(2) of the Code. Marjorie Fleming Lloyd-Smith, 40 B. T. A. 214,affirmed on another point(C. A. 2) 116 F. 2d 642,certiorari denied313 U. S. 588, followed.
3. The corporation, at the time of its insolvency, owed admissions, withholding, and social security taxes. Petitioner paid part of those taxes upon being informed by an internal revenue official and his own attorney that he was personally liable therefor. Held, the tax payments were not made by petitioner as a volunteer but in response to the internal revenue official's demand and under the reasonable belief that he was liable therefor as an officer and director of the corporation. He is entitled to nonbusiness loss deductions for those payments under section 23(e)(2) of the Code. He does not claim them as tax deductions under section 23(c) of the Code. Herbert M. Matties, Esq., for the petitioners. S. Jarvin Levison, Esq., for the respondent.
The Commissioner determined deficiencies of $1,145.26 and $527.06 in petitioners' income taxes for 1948 and 1949, respectively. The issues raised are:
(1) Whether petitioners are entitled to a nonbusiness loss deduction, under section 23(e)(2) of the Internal Revenue Code, for a $3,000 payment made in 1948 in settlement of petitioner Peter Stamos' liability as guarantor of notes owed by Paramount Exposition Shows, Inc. (a corporation of which he was a stockholder, officer, and director), or whether petitioners are limited to deduction of that $3,000 payment as a nonbusiness bad debt under section 23(k)(4) of the Code.
(2) Whether petitioners are entitled to a deduction, under either section 23(a)(1)(A), 23(a)(2), or 23(e)(2) of the Code, for legal expenses of $264.77 paid in 1949 in connection with the settlement mentioned in (1) above.
(3) Whether petitioners are entitled to loss deductions, under section 23(e)(1) or (2) of the Code, for payments of $6,355 in 1948 and $2,658.85 in 1949 made to the collector of internal revenue on account of sundry taxes owed by Paramount Exposition Shows, Inc. The payments in question are stipulated to have been made. The Commissioner, however, in his determination of the deficiencies disallowed the deductions. In his disallowance of the $6,355 which the petitioners claimed for 1948, the Commissioner stated in his deficiency notice as follows:
(a) A deduction of $6,355.00, that represents sundry taxes which you paid for Paramount Exposition Shows, Inc., is held not to constitute an allowable deduction in your individual income tax return under the provisions of the Internal Revenue Code. A similar explanation was made by the Commissioner of his disallowance of the $2,658.85 which petitioners paid in 1949 and claimed as a deduction.
The deductions in (1) and (2) above were not claimed by petitioners on their returns for the years involved but consideration thereof was appropriately raised in the pleadings. Moreover, petitioners contend that they overpaid income taxes in 1948 and 1949 by $192.70 and $67.38, respectively, and are entitled to refunds therefor.
FINDINGS OF FACT.
Most of the facts hereinafter found were stipulated by the parties and that stipulation is incorporated herein by reference.
Petitioners, Peter Stamos and Catherine C. Stamos, are husband and wife. During all times here material they resided in Binghamton, New York, and filed joint income tax returns on the cash basis with the collector of internal revenue for the twenty-first district of New York. Catherine C. Stamos is involved in this proceeding only as a result of the fact that joint returns were filed for 1948 and 1949. Consequently, references hereinafter to petitioner are intended as references to Peter Stamos.
Petitioner, since about 1930 or 1931, has been a concessionaire associated with the James E. Strates traveling road shows. Such shows are commonly referred to as carnivals. Late in 1946 petitioner, Samuel J. Lipsih, and Ralph J. Flannigan contracted to purchase a carnival from Richard Gilsdorf and others. Petitioner at that time gave Gilsdorf a $2,500 note to cover part of the purchase price. Before deciding to participate in the purchase of the carnival petitioner first consulted James E. Strates and was influenced by Strates' opinion that he (petitioner) would prosper from the venture.
On January 6, 1947, petitioner, Lipsih, and Flannigan organized Paramount Exposition Shows, Inc., a New York corporation (hereinafter referred to as the corporation). Petitioner invested $5,833.35 in the capital stock of the corporation and, further, loaned $7,000 to the corporation. He was elected treasurer and a director of the corporation but took no part in its active management or control and was paid no compensation in those posts. The corporation entered into an agreement with Flannigan, who had been elected president, constituting him general manager of the corporation for one year at a salary of $8,000 and pursuant to which Flannigan conducted all of the corporation's operations. In fact, petitioner continued to travel with the James E. Strates shows during the time the corporation was conducting operations.
Petitioner, Lipsih, and Flannigan transferred to the corporation their contract to purchase the carnival from Gilsdorf. The corporation, in turn, assumed the obligation to pay both the $2,500 note petitioner had theretofore given Gilsdorf and the $47,500 balance of the purchase price of the carnival. To cover that balance the corporation gave Gilsdorf $7,500 in cash and two $20,000 corporate notes. The notes were dated January 6, 1947, were secured by a chattel mortgage on the equipment purchased from Gilsdorf, and were endorsed by petitioner, Lipsih, and Flannigan as guarantors. Petitioner was not in the trade or business of promoting, financing, managing, or making or guaranteeing loans of corporations of business enterprises. His only trade or business in 1948 and 1949 was that of concessionaire with the James E. Strates shows.
The corporation failed to prosper. Having no funds with which to meet obligations, the corporation, some time prior to December 1, 1947, discontinued and never again resumed operations. Its equipment was repossessed by Gilsdorf pursuant to the chattel mortgage and sold at a public auction held on or about February 16, 1948. The amount realized on the sale was less than the unpaid balance due and owing on the two corporate notes. The corporation was in fact in solvent at least from and after December 1, 1947. Petitioner never received any assets from the corporation as a stockholder nor was he ever repaid any portion of the $7,000 loan he had made to it. The corporation was finally dissolved on December 15, 1950.
On March 12, 1948, petitioner was sued on a $2,500 note he had given as a substitute for the original $2,500 note to Gilsdorf (which note the corporation had assumed to pay). To settle both that action and his guarantor's obligation on the two $2,000 corporate notes petitioner, on October 2, 1948, paid the sum of $3,000. On January 6, 1949, he paid $264.77 for legal expenses incurred in concluding the aforementioned settlement. A right arose in favor of petitioner to be reimbursed by the corporation for the $3,000 payment but such right was worthless when acquired. On the other hand, there is no evidence that a right of reimbursement arose in petitioner's favor for the $264.77 paid for legal expenses. Petitioner did not deduct the aforementioned payments from his 1948 and 1949 returns but raised the issue of their deductibility by appropriate pleadings in this case.
In December 1947, petitioner, Lipsih, Flannigan, and their attorney met with the official then in charge of the Rochester, New York, office of the collector of internal revenue to discuss admission taxes, social security taxes, and withholding taxes which the corporation owed but had not paid. The internal revenue official stated that, as officers and directors of the corporation, petitioner, Lipsih, and Flannigan were personally liable both civilly and criminally for those taxes and that, if they were not paid, action would be taken to collect them. Petitioner's attorney advised him that he would be civilly, although not criminally, liable for those taxes. Consequently, an arrangement was made whereby petitioner, who did not have sufficient cash on hand, was to pay a portion of those taxes in installments. Pursuant to that arrangement petitioner paid the collector $6,355 in 1948 and $2,658.85 in 1949. Petitioner only made those payments because he believed himself liable therefor and because he believed that otherwise action to collect them would be instituted against him. They were in no sense voluntary payments made on behalf of the corporation.
Petitioner deducted the aforementioned tax payments from his returns for the years in which paid. There was never any reasonable possibility of his being reimbursed by the corporation for those payments.
Petitioner's return for 1948 was filed on or about March 15, 1949, at which time he paid income tax of $192.70 for that year. His return for 1949 was filed on or about March 15, 1950, at which time he paid income tax of $1,096.18 for that year. The deficiency notice was mailed on February 8, 1952, less than 3 years after petitioner's returns were filed and his taxes paid for 1948 and 1949.
OPINION.
BLACK, Judge:
On October 2, 1948, petitioner paid $3,000 in settlement of his guarantor's liability on various obligations of the corporation. At the time petitioner gave his guaranty he expected the corporation to prosper and did not contemplate that he would be called upon to make payment under that obligation. When petitioner made the $3,000 payment the corporation was insolvent and was not conducting business operations. His right of reimbursement against the corporation was in fact worthless. However, the corporation was still then in existence and was not dissolved until December 15, 1950.
Petitioner contends that the $3,000 payment is deductible from his 1948 gross income as a nonbusiness loss under section 23(e)(2) of the Code.
Respondent argues that the payment may be deducted only as a nonbusiness bad debt under section 23(k)(4) of the Code.
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:* * * * * * *(e) LOSSES BY INDIVIDUALS.—In the case of an individual, losses sustained during the taxable year and not compensated for by insurance or otherwise—* * * * * * *(2) if incurred in any transaction entered into for profit, though not connected with the trade or business; or * * *
The two sections are mutually exclusive; if an item qualifies for deduction under section 23(k)(4), it cannot then be deducted under the more liberal provisions of section 23(e)(2). Spring City Foundry Co. v. Commissioner, 292 U. S. 182. The particular question to be resolved is whether a debt arose in favor of petitioner against the insolvent but still existent corporation when petitioner paid the $3,000. If it did then section 23(k)(4) is the provision under which the petitioner must take his deduction.
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:* * * * * * *(k) BAD DEBTS.—* * * * * * *(4) NON-BUSINESS DEBTS.—In the case of a taxpayer, other than a corporation, if a non-business debt becomes worthless within the taxable year, the loss resulting therefrom shall be considered a loss from the sale or exchange, during the taxable year, of a capital asset held for not more than 6 months. The term ‘non-business debt’ means a debt other than a debt evidenced by a security as defined in paragraph (3) and other than a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.
Since the corporation was not dissolved until December 15, 1950, this case is distinguishable from those holding that no debt arose in guarantor's favor when the principal debtor was not in existence at the time the guarantor satisfied his obligation. Abraham Greenspon, 8 T. C. 431; Frank B. Ingersoll, 7 T. C. 34; Fox v. Commissioner, (C. A. 2) 190 F. 2d 101, reversing 14 T. C. 1160. In George Aftergood, 21 T. C. 60, our most recent case in point, we stated:
When a guarantor ‘is forced to answer and fulfill his obligation of guaranty, the law raises a debt in favor of the guarantor against the principal debtor.’ Kate Baker Sherman, 18 T. C. 746, 751 (1952). It does not matter that the obligation raised by the law was totally worthless when it arose. Agnes I. Fox, 14 T. C. 1160 (1950), revd. 190 F. 2d 101 (C. A. 2, 1951); Barnhart-Morrow Consolidated, 47 B. T. A. 590 (1942), affd. 150 F. 2d 285 (C. A. 9, 1945). Other decisions supporting this position are, inter alia, Shiman v. Commissioner, (C. A. 2) 60 F. 2d 65; Daniel Gimbel, 36 B. T. A. 539; D. W. Pierce, 41 B. T. A. 1261; and Leo L. Pollak, 20 T. C. 376. We are aware of the recent reversal of the Pollak case, (C. A. 3) 209 F. 2d 57. However, after carefully reexamining the problem we respectfully decline to follow the Court of Appeals for the Third Circuit in its reversal of that case. Consequently, we hold that upon payment of the $3,000 by petitioner a debt arose running from the corporation to petitioner, that such debt was worthless when it arose, and that petitioner's deduction therefor may properly be taken only under section 23(k)(4).
On January 6, 1949, petitioner paid $264.77 for legal expenses incurred in settling his aforementioned guarantor's liability on the corporation's obligations. There is no evidence that petitioner acquired a right of reimbursement against the corporation for those expenses. Petitioner contends that those expenses are deductible, in computing net income for 1949, either as an expense under section 23(a)(1)(A) or 23(a)(2) of the Code, or as a loss incurred in a ‘transaction entered into for profit’ under section 23(e)(2) of the Code, supra.
We think this case clearly falls within the ambit of our decision in Marjorie Fleming Lloyd-Smith, 40 B. T. A. 214, affirmed on another point (C. A. 2) 116 F. 2d 642, certiorari denied 313 U. S. 588, in which we held that the taxpayer, who incurred legal expenses in adjusting her guarantor's liability on bonds of a corporation in which she was a stockholder, could deduct those expenses as losses on a ‘transaction entered into for profit’ under section 23(e)(2). In the instant case the guaranty itself was given by the petitioner to facilitate the purchase of the carnival which was to be run by the corporation in which petitioner was a stockholder, officer, and director. Petitioner entered the carnival venture, forming and investing in the corporation, because he thought he would prosper from it. Obviously, therefore, the guaranty was given in a transaction entered into for profit. See generally Moses Cohen, 44 B. T. A. 709, 713; Carl Hess, 7 T. C. 333. When petitioner paid the legal expenses in connection with the guaranty, the corporation was insolvent and his investment therein was worthless. Those legal expenses were paid for the sole purpose of reducing petitioner's liability under the guaranty. On these facts we think, as a foresaid, that Marjorie Fleming Lloyd-Smith, supra, is controlling and that petitioner is entitled to deduct the legal expenses under section 23(e)(2).
Both petitioner and respondent have cited, in support of their arguments regarding the deductibility of the legal expenses, Bingham's Trust v. Commissioner, 325 U. S. 365, and Lykes v. United States, 343 U. S. 118. Those cases deal with the propriety of deductions for legal expenses under section 23(a) of the Code. Since we have held that petitioner here is entitled to a loss deduction under section 23(e)(2) it is unnecessary to consider the applicability of section 23(a) to this issue.
We turn now to the final issue for consideration. The corporation owed the Federal Government admissions, withholding, and social security taxes. Because of its insolvency and the discontinuance of its operations it was unable to pay those taxes. At a conference held in December 1947, the official in charge of the local office of the collector of internal revenue told petitioner that he was personally liable, both civilly and criminally, for those taxes and that if they were not paid action would be taken to collect them. Petitioner's attorney, moreover, advised petitioner that he was civilly liable for the taxes. Solely as a result of what in effect was the internal revenue official's demand for payment of the aforementioned taxes, and petitioner's honest belief (corroborated by his attorney's advice) that he was personally liable for them, an arrangement was entered into whereby petitioner paid the collector installments totaling $6,355 in 1948 and $2,658.85 in 1949 on account of those taxes. There was never any reasonable possibility of petitioner's being reimbursed by the corporation for those payments.
Petitioner does not contend that he is entitled to deduct the payments as ‘taxes' under section 23(c) of the Code since the taxes owed by the corporation were not levied against him. Petitioner does claim, however, that the payments which he made arose out of the fact that he was a stockholder, officer, and director of the corporation and that the evidence is clear that petitioner did not pay the taxes as a volunteer.
Petitioner contends that the tax payments constitute either losses ‘incurred in trade or business' under section 23(e)(1) of the Code or nonbusiness losses under section 23(e)(2), supra and that he therefore is entitled to deductions for them in the years paid. Since petitioner never received any assets from the corporation his alleged liability for its delinquent taxes arose solely out of his position as an officer and director. It is clear from our findings of fact, however, that petitioner's only ‘trade or business' during 1948 and 1949 was as a concessionaire with the James E. Strates shows. Although he was an officer and director of the corporation, he took no active part in the management of the corporation's affairs. Consequently, the alleged losses could in no case be regarded as ‘incurred in trade or business' under section 23(e)(1). Hadwen C. Fuller, 21 T. C. 407. On the other hand, petitioner's whole relationship with the corporation, as a stockholder, officer, and director, was clearly for the purpose and with the intent of making a profit from the venture. If therefore, the tax payments constitute losses they would qualify for deductions as nonbusiness losses, under section 23(e)(2), since they were incurred in connection with and as a result of petitioner's position as an officer and director. See Moses Cohen, Carl Hess, and Marjorie Fleming Lloyd-Smith, supra.
Respondent contends that there is no evidence that petitioner was in fact personally liable for the corporation's taxes and that petitioner's payments thereof were voluntary and not deductible as losses. Whether petitioner was as a matter of law liable for those taxes is not the desideratum. An internal revenue official stated to petitioner that he was liable and that if payment was not made appropriate action would be instituted. We think the official's statement constituted an administrative demand for payment. It was plainly so intended. The business community generally ascribes prima facie validity to such demands and is, as a practical matter, generally compelled thereby. Baltimore Transfer Co., 8 T. C. 1. Moreover, petitioner's attorney agreed with the official that petitioner was civilly liable for those taxes. Petitioner, therefore, had genuine reason to, and did, believe himself liable. He paid the taxes only because of that belief and not as a mere volunteer. How the Commissioner can contend, under the undisputed facts which are in the record, that petitioner paid these taxes as a volunteer is more than we can see. We think that petitioner may properly deduct these payments as nonbusiness losses even though an adjudication on the issue might prove him free from liability. E. L. Bruce Co., 19 B. T. A. 777; Guitar Trust Estate, 34 B. T. A. 857. Cf. Great Island Holding Corporation, 5 T. C. 150; William L. Butler, 17 T. C. 675.
Our holding is not affected by the fact that there was no evidence of an attempt by petitioner to obtain refunds of those payments and of the failure of the attempt. We do not believe that the petitioner need seek a complete review and adjudication of a liability which is colorable and has been bona fide asserted against him, even though doubts may exist as to its validity. See E. L. Bruce, Great Island Holding Corporation, William L. Butler, supra. A loss deduction may be taken when, as here, such a liability has been paid. As stated in United States v. S. S. White Dental Mfg. Co., 274 U. S. 398, ‘a loss may become complete enough for deduction without the taxpayer's establishing that there is no possibility of an eventual recoupment.’
Decision will be entered under Rule 50.