Froehlich v. Commissioner

T.C. Memo. 1996-487

UNITED STATES TAX COURT

LEE D. FROEHLICH, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 15382-94. Filed October 19, 1996.

P, P’s accountant, and R’s counsel engaged in a
pretrial conference. The conference began with a
discussion of settlement. R’s counsel did not believe
that settlement would be achieved and, from his
perspective, he began what he believed to be a
discussion of matters to be stipulated for trial. P
and his accountant, who were not familiar with the
pretrial procedures of this Court, believed that the
settlement discussions had continued. The matter
discussed between R’s counsel, P, and P’s accountant
involved whether there had been a duplication of a
$400,000 amount and whether P was entitled to losses
that were capital or ordinary in character. R, at
trial, offered statements made by or on P’s behalf as
admissions against P’s interest. P contends that Fed.
R. Evid. 408 prohibits R’s offer of admissions because
the statements were made in the context of settlement
negotiations.
Held: Under Fed. R. Evid. 408 both offers of
settlement and statements made during settlement
negotiations are not admissible to prove liability or
 - 2 -

invalidity of a claim. Held, further: It was
substantially unclear to P and his accountant that
settlement negotiations had concluded; any admissions
made are not admissible under Fed. R. Evid. 408. Held,
further: P’s loss was capital in nature. Held,
further: P is not liable for the accuracy-related
penalty under sec. 6662(a), I.R.C. for reasons stated
herein.

Steve Mather, for petitioner.

Mark A. Weiner, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge: Respondent determined a deficiency in

petitioner's 1987 Federal income tax in the amount of $94,794,

and an addition to tax pursuant to section 66611 in the amount of

$23,699. Respondent also determined a deficiency in petitioner's

1990 Federal income tax in the amount of $4,983 and an accuracy-

related penalty pursuant to section 6662(a) of $997.

The principal controversy here is whether petitioner has

established that his dominant motivation in guaranteeing the

floor plan line of credit was to secure or protect his trade or

business of being an employee. This, in turn, controls whether

petitioner is entitled to deduct a $400,000 payment made to a

bank as a business bad debt pursuant to section 166(a). If we

1
All section references are to the Internal Revenue Code in
effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
 - 3 -

determine that it is not deductible as a business bad debt, then

petitioner is entitled to claim the $400,000 as a short-term

capital loss; i.e., a nonbusiness bad debt. Sec. 166(d)(1) and

(2). We also consider whether petitioner is liable for an

accuracy-related negligence penalty pursuant to section 6662(a)

for the taxable year 1990.2

FINDINGS OF FACT3

Lee D. Froehlich (petitioner), at the time of the petition

in this case, resided in Simi Valley, California. Petitioner, at

various times, has been engaged in the field of selling new and

used automobiles. Petitioner's professional career has been in

the retail automobile business, including positions such as

salesperson, sales manager, general manager, and, ultimately,

owner of a dealership. For the relevant years, petitioner was

president and owner of FRO Enterprises, Inc., an Acura automobile

dealership (the auto dealership).

In 1967, petitioner was inducted into the U.S. Army, thus

interrupting his college education at the University of Nebraska.

In 1969, petitioner began developing skills and expertise selling

automobiles in Kansas City, Kansas. Petitioner also received

management training during this particular interval. From 1972

2
Respondent has conceded that petitioner is not liable for
the sec. 6661 addition to tax for the taxable year 1987.
3
The parties' stipulations of facts and exhibits are
incorporated by this reference.
 - 4 -

through 1975, petitioner was employed by automobile dealerships

in Montana, where he met Mr. Jack Robertson (Robertson), who

offered him a job selling Honda automobiles. Petitioner was

employed by Robertson Honda during 1975 through 1977. For the

next year and a half, petitioner was the manager of used-car

sales at a Ford dealership.

In 1979, petitioner returned to Robertson Honda and worked

there until 1986. During the last several years of his

employment in Robertson Honda, petitioner was the general

manager, and he earned $318,172 and $202,612 for 1985 and 1986,

respectively. Petitioner enjoyed an "excellent" working

relationship with Robertson. However, petitioner believed there

was no room for further advancement within Robertson Honda.

Also, petitioner surmised that his position with Robertson Honda

was precarious because he was making twice as much as other

general managers in comparable employment.

Petitioner believed that if he owned his own auto

dealership, he could earn several times his earnings at Robertson

Honda, which averaged $250,000 annually in the years approaching

1986. Petitioner believed that the general manager of the

Flagstaff dealership earned approximately $100,000 to $150,000

annually. Petitioner believed that the owner of his own

dealership could earn $750,000 annually. Petitioner understood

that Robertson initially earned $500,000 per year, but ultimately
 - 5 -

increased his salary to $3 million. Petitioner desired to attain

that level of compensation. He also sought to work less hours

and to pursue leisure activities such as golf. Thus, petitioner

wanted to own an auto dealership in order to maximize career and

salary opportunities.

Robertson assisted petitioner in obtaining an automobile

dealership franchise from American Honda Motor Co., Inc.

(American Honda). American Honda advised that Honda dealerships

were not available and suggested, instead, an Acura dealership.

The Acura dealership, however, could only be assigned to

Robertson because of American Honda company rules that required

preference be given to current dealers. Acura offered Robertson

a dealership in the San Fernando Valley in southern California.

On March 1, 1985, the Acura Automobile Division, a

subsidiary of American Honda, submitted a letter of intent to

Robertson that his application for an Acura automobile dealership

had been tentatively approved. Robertson was assigned the area

around Woodland Hills, California. The letter of intent

contained the estimate that the land and building would cost

approximately $126,882 to conform to Acura's requirements and

that the facility was to be completed no later than March 15,

1986. Finally, American Honda notified Robertson that, as part

of its marketing strategy, another Acura dealership would be

opening in nearby Van Nuys, California.
 - 6 -

Robertson sold petitioner the rights to the Acura dealership

for the nominal sum of $1. Petitioner submitted a business plan

to American Honda. Subsequently, American Honda issued the Acura

dealership to petitioner. The auto dealership, however, was

ultimately located in Calabasas, California.

As a prerequisite to obtaining the Acura dealership,

American Honda required petitioner to invest $806,000 in capital

assets. At that time, petitioner had no major financial

obligations, and he possessed financial resources of

approximately $250,000. Petitioner expected to borrow the

balance of the money needed to meet the $806,000 capital

threshold.

Intially, petitioner contributed $209,163 in cash to the

auto dealership. Of this amount, $196,921.05 was expended for

deposits, legal fees, signs and logos, office supplies, office

furniture, ceremony expenses, secretarial salaries, public

relations, promotional expenses, and transfers to business

accounts. Petitioner also selected the location of the auto

dealership as well as the design, acquired approval from county

and State authorities, hired and trained staff, and engaged in

other preliminary matters.

In petitioner's auto dealership's financial statement, his

cash contribution was reflected as "Other" in the category "Total

Current Assets". Petitioner also contributed two automobiles,
 - 7 -

with a total value of approximately $40,000. These items were

placed in the auto dealership's used car inventory, and were

deemed to be assets on the company's books. As part of the

$806,000 capital requirement, petitioner executed a note in favor

of the auto dealership for approximately $150,000. At the end of

the first year of the business, petitioner paid off this note

from a bonus of $236,000 that he received from the auto

dealership.

The additional $400,000 needed to meet the $806,000 capital

requirement was to be borrowed from Golden State Sanwa Bank

(Sanwa Bank). In a July 9, 1986, letter setting forth Sanwa

Bank's terms and conditions for the capitalization loan (cap

loan), petitioner is denominated as "Borrower" and the auto

dealership as the "Guarantor". The stated purpose of the loan is

for "Permanent Working Capital".

On March 2, 1987, Sanwa Bank entered into a business loan

agreement with petitioner for the cap loan. The $400,000

promissory note contains the statement that the loan is "To

assist with investment in auto dealership to meet permanent

working capital needs of enterprise." Petitioner is shown as the

borrower, and his occupation is listed as owner of the

dealership. On the same date, a Sanwa Bank corporate resolution

reflects that the auto dealership guaranteed the repayment of
 - 8 -

petitioner's debt, and petitioner is denominated as "President"

of the corporate entity, FRO Enterprises, Inc.

Finally, Sanwa Bank prepared two documents that were both

entitled "Continuing Guaranty". The first one, typewritten and

dated March 2, 1987, states that the cap loan of $400,000 was

made to the auto dealership. In this document, petitioner is

denominated "Guarantor" and the auto dealership "Debtor". On the

top front page of the first document is the word "Backwards" in

handwriting. The second document bears a handwritten date of

March 2, 1987. The second document extends the cap loan to

petitioner, and the auto dealership is listed as the "Guarantor".

On top of the second document is handwritten: "$400,000 cap

loan, 9/27/89, to replace note signed backwards".

Cap loans were common in the automobile industry.

Typically, these loans were made to the corporate entities.

Petitioner's bank records, however, reflect that he deposited the

$400,000 cap loan proceeds into his personal account and then

transferred the funds to the auto dealership. The March 1987

dealer financial statement reflected petitioner's initial capital

contribution consisting of the $400,000 cap loan and petitioner's

other contributions of approximately $400,000.

On July 9, 1986, petitioner obtained a $2,500,000 floor plan

line of credit. The auto dealership is listed as the "Borrower".

This particular loan was required to be renewed annually. A
 - 9 -

floor plan loan is intended to finance the purchase of new car

inventory through the time they are sold. Under floor plan

loans, the lender purchases automobiles that are received in the

auto dealership's inventory. Each time an automobile is sold,

the dealership is required to pay the lender the cost of that

automobile.

On August 4, 1987, Sanwa Bank informed the auto dealership,

attention of petitioner, that the floor plan line of credit for

$2,500,000 had been increased to $3,500,000, effective July 29,

1987. The auto dealership, represented by petitioner, in an

unsigned and undated document entitled "Certified Corporate

Resolution To Borrow", sought to borrow up to $3,500,000 from

Sanwa Bank.

On July 31, 1988, Sanwa Bank increased the floor plan loan

to $5 million. Sanwa Bank issued a promissory note entitled

"Commercial Optional Advance Promissory Note". Petitioner's name

is shown on the document as president of the auto dealership. On

the same date, in a related document entitled "Continuing

Guaranty", petitioner was listed as "Guarantor".

Petitioner's auto dealership opened March 1987 and during

the first 2 years, it was the number one Acura dealer in the

United States. In the middle of 1989, petitioner's auto

dealership began experiencing financial reverses because of an

economic downturn in the State of California and because of the
 - 10 -

introduction of another luxury automobile (Lexus). Finally, two

other Acura dealers in Thousand Oaks and Van Nuys, California,

respectively, opened sometime in 1989.

When petitioner's auto dealership suffered financial

reverses, it fell "out of trust" on its floor plan. A floor plan

is out of trust when the remaining inventory of automobiles is

insufficient to cover the floor plan loan. Consequently, there

was a possibility that Sanwa Bank would not renew the floor plan

loan. Sanwa Bank required petitioner to reduce the amount

outstanding on the floor plan. In order to reduce the amount

outstanding, petitioner decided to sell his home and disburse a

significant portion of the proceeds to Sanwa Bank. Petitioner

was compelled to reduce the amount "out of trust" with respect to

the floor plan loan because he had personally guaranteed the

entire amount, and, if Sanwa Bank chose not to renew the loan,

the auto dealership would have gone out of business.

On October 15, 1989, the auto dealership entered into an

agreement to extend and/or modify a promissory note for the floor

plan. In this agreement, the maturity of the July 31, 1988,

promissory note was extended to December 1, 1989. Petitioner, as

president of the auto dealership, signed the agreement as

"Borrower".

On February 5, 1990, petitioner irrevocably transferred a

Deed of Trust for petitioner's home to Sanwa Bank. The Deed of
 - 11 -

Trust states that Sanwa Bank, as the beneficiary, would receive

payment of an indebtedness in the amount of $400,000. On

February 6, 1990, Sanwa Bank presented the escrow company with a

demand note as well as the original, unrecorded, Deed of Trust

for petitioner's home. It was Sanwa Bank's understanding that

the escrow company would disburse $400,000 to Sanwa Bank at the

close of escrow.

On March 2, 1990, petitioner's home was sold for $1,225,000,

and Sanwa Bank received $400,000 from the sale proceeds. Sanwa

Bank applied the funds distributed from the escrow company toward

the floor plan loan. Ultimately, however, on April 30, 1990,

Sanwa Bank did not renew the floor plan loan, and, instead,

foreclosed on petitioner's auto dealership and liquidated and

sold the assets. Afterwards, Sanwa Bank sought payment for the

approximately $1.1 million outstanding balance due on the floor

plan loan. Petitioner did not receive any of the foreclosure

proceeds.

On the auto dealership's Federal income tax returns for the

1987 through 1990 tax years, it reported the following:

Years Gross Receipts Gross Profit Total Income1 Taxable Income
1987 $27,674,310 $3,010,606 $3,959,332 $43,644
1988 35,089,014 3,587,666 4,554,151 (271,712)
1989 35,522,931 4,101,084 4,889,409 (570,637)
1990 4,713,561 588,810 239,916 (699,459)

1
This column reflects gross profits plus other income such
as cash discounts, miscellaneous income, finance and insurance
income, as well as service contracts.
 - 12 -

Petitioner reported on his Federal income tax returns the

following amounts of income:

Years Salary
1985 $318,172
1986 202,612
1
1987 516,233
1988 180,000
1989 152,400
2
1990 127,700
1991 127,000
1992 104,000
1993 104,000
1994 156,000
1
This figure has been rounded off to the nearest dollar. In
that year, petitioner obtained a salary of $280,000, and received
a bonus of $236,000. The bonus went back to petitioner's auto
dealership to pay off the $150,000 note and a $80,000 loan he
received from the dealership.
2
Petitioner received $45,200 prior to the loss of his auto
dealership.

As a dealer/owner, petitioner received a total of $893,833 in

income from the auto dealership while it was in business.

Petitioner, on Schedule D of his 1990 Federal income tax

return, claimed $350,000 in capital losses under section 1244 and

an additional, unspecified, $50,000 loss. In addition, the

$400,000 paid to Sanwa Bank from the foreclosure proceeds was

claimed as a loss on petitioner's Schedule C as "personal

guarante [sic] of loan from corporation".

After the termination of petitioner's auto dealership, he

worked almost 6 months as the manager of a Ford dealership in

Orange County, California. Thereafter, Acura requested

petitioner to assist a Huntington Beach, California, dealer.
 - 13 -

Petitioner worked in the Huntington Beach dealership for

approximately 1 year. He then worked for a Honda dealership in

Pasadena, California, for 1 year. As of the time of trial,

petitioner had been working for approximately 2 years with a Ford

dealership in Thousand Oaks, California.

Petitioner's accountant, Jesse Greenspan (Mr. Greenspan) was

not aware that petitioner had personally borrowed $400,000 from

Sanwa Bank. Petitioner's auto dealership's accountant, Judith

Rugh (Ms. Rugh), worked for an accounting firm that provided

services for approximately 30 clients which were auto

dealerships. Ms. Rugh believed that, generally, petitioner's

business maintained a fairly accurate set of books. Ms. Rugh

also believed that petitioner's salary for the 1987 calendar year

was probably low when compared to other auto dealers that she was

familiar with.

On September 22, 1995, respondent's representatives met with

petitioner and his accountant. The meeting lasted approximately

2 hours. Respondent's counsel believed that the purpose of the

meeting was to engage in preparation for trial. Petitioner and

his accountant, Mr. Greenspan, believed that it was a settlement

conference concerning the $400,000 capital contribution claimed

as a stock loss and whether that was a different amount from the

$400,000 bad-debt deduction. Petitioner and Mr. Greenspan

presented numerous documents to prove that there were two
 - 14 -

$400,000 amounts involved in the questioned transactions. These

documents were photocopied by respondent's counsel and an

assistant.

The conference began with a settlement discussion between

petitioner and respondent's counsel. The brief settlement

discussion was followed by the consideration of the merits of

respondent's legal stance. During the conference, respondent's

counsel informed petitioner and his accountant about the Tax

Court's stipulation requirement. Towards the end of the meeting,

respondent's counsel advised petitioner to obtain counsel. After

the meeting, petitioner and respondent's counsel engaged in a

series of telephone conversations discussing whether there were

two separate $400,000 amounts claimed in the 1990 Federal income

tax return or whether there had been a duplication of a $400,000

amount.

Prior to trial, the counsel who represented respondent

during the pretrial phase withdrew to enable him to testify about

statements made by or on behalf of petitioner at the conference.

New counsel represented respondent at the trial.

OPINION

The primary issue for our consideration is whether petitioner's

loss of $400,000 resulting from his guaranty is deductible as

"ordinary" or "capital". Preliminary to considering the merits

of the primary issue, we consider an evidentiary matter.
 - 15 -

A. Evidentiary Matter

At trial, respondent proffered her counsel's testimony to

offer admissions against interest made by or on behalf of

petitioner. See Fed. R. Evid. 801(d)(2). Petitioner seeks to

exclude all of respondent's counsel's testimony on the ground

that it consisted of statements made in the course of settlement

negotiations.

Proceedings in this Court are conducted in accordance with

the Federal Rules of Evidence. Sec. 7453; Rule 143. Rule 408 of

the Federal Rules of Evidence provides as follows:

Rule 408. Compromise and Offers to Compromise

Evidence of (1) furnishing or offering or
promising to furnish, or (2) accepting or offering or
promising to accept, a valuable consideration in
compromising or attempting to compromise a claim which
was disputed as to either validity or amount, is not
admissible to prove liability for or invalidity of the
claim or its amount. Evidence of conduct or statements
made in compromise negotiations is likewise not
admissible. This rule does not require the exclusion
of any evidence otherwise discoverable merely because
it is presented in the course of compromise
negotiations. This rule also does not require
exclusion when the evidence is offered for another
purpose, such as proving bias or prejudice of a
witness, negativing a contention of undue delay, or
proving an effort to obstruct a criminal investigation
or prosecution.

This proscription is limited to evidence of settlement

negotiations and documents concerning the compromise of a claim.

In addition, the limitation on using such evidence applies only
 - 16 -

when it is being offered to show liability, or that some

underlying claim is invalid. Id.

The legislative history of rule 408 of the Federal Rules of

Evidence indicates that the purpose thereof is to encourage

settlements. See United States v. Contra Costa County Water

Dist., 678 F.2d 90, 92 (9th Cir. 1982); Central Soya Co. v.

Epstein Fisheries, Inc., 676 F.2d 939, 944 (7th Cir. 1982);

Hulter v. Commissioner, 83 T.C. 663, 665 (1984). The underlying

premise is that, without the rule, settlement negotiations would

be inhibited if the parties knew that statements made in the

course of settlement might later be used against them as

admissions of liability. United States v. Contra Costa County

Water Dist., supra at 92; Central Soya Co. v. Epstein Fisheries,

Inc., supra at 944; Hulter v. Commissioner, supra at 665.4

Petitioner contends that a meeting with respondent's counsel

was a settlement conference, and, hence, statements made by

4
See also Saltzburg & Redden, Federal Rules of Evidence
Manual, 191 (3d ed. 1982):

In most cases * * * the Court should
decide against admitting statements made
during settlement negotiations as impeachment
evidence when they are used to impeach a
party who tried to settle a case but failed.
The philosophy of the Rule [408] is to allow
the parties to drop their guard and to talk
freely and loosely without fear that a
concession made to advance negotiations will
be used at trial. Opening the door to
impeachment evidence on a regular basis may
well result in more restricted negotiations.
 - 17 -

petitioner are within the ambit of rule 408 of the Federal Rules

of Evidence. Petitioner primarily relies on the second sentence

of rule 408 of the Federal Rules of Evidence, which states

"Evidence of conduct or statements made in compromise

negotiations is likewise not admissible." The exception

contained within rule 408 of the Federal Rules of Evidence for

"evidence otherwise discoverable" mitigates the general rule

where evidence is discoverable from a source independent of the

settlement negotiations. See Hulter v. Commissioner, supra, at

665-666. The purpose of this exception is to prevent parties

from insulating evidence that is obviously damaging to them by

incorporating the evidence in settlement discussions and/or

offers.

In general, rule 408 of the Federal Rules of Evidence states

a broad proscription excluding statements made during settlement

negotiations when offered to prove the validity or amount of a

claim. Specifically, this rule does not distinguish between

offers to settle and admissions of fact made during settlement

negotiations. See Fiberglass Insulators, Inc. v. Dupuy, 856 F.2d

652 (4th Cir. 1988). Accordingly, the issue here is not whether

the statement was one that was made as an offer to settle, but

whether it was made during settlement negotiations.

Thus, we must inquire here, as a factual matter, whether

petitioner's admissions were made during a settlement conference.
 - 18 -

Petitioner and Mr. Greenspan believed that the case could be

settled if it could be established that there were two distinct

elements in petitioner's 1990 Federal income tax return--the

$400,000 capital contribution taken as a loss and the $400,000

bad-debt deduction. Petitioner and Mr. Greenspan brought records

to substantiate this particular contention. During this meeting,

the records were photocopied by respondent's counsel and his

assistant. This, in addition to the obvious settlement

discussion in the beginning of the meeting, caused petitioner to

believe that the entire session was for the purpose of

settlement.

Respondent's counsel, who is sophisticated and experienced

in such matters, delineated between the initial settlement

discussion and the beginning of the process of stipulating facts

for trial. Petitioner and Mr. Greenspan, however, were not

sophisticated and experienced in such matters. It was only

toward the end of the meeting, when respondent's pretrial counsel

advised petitioner to obtain counsel, that it could have become

clear to them that the subject matter had turned to preparation

for trial as opposed to settlement discussions. In addition, the

subsequent telephonic discussions between petitioner and

respondent's counsel concerned the question of duplicated

$400,000 amounts and could have given petitioner the impression

that the possibility of settlement was still under discussion.
 - 19 -

In sum, the record does not persuade us that settlement

discussions had ended prior to the purported admissions by

petitioner. Examining the totality of the circumstances, we

believe it is consonant with the purpose of rule 408 of the

Federal Rules of Evidence, to decline to include the purported

statements made by petitioner in the record. Hence, petitioner's

motion to exclude respondent's counsel's testimony will,

accordingly, be granted.

B. Capital Versus Ordinary Loss

Petitioner guaranteed the auto dealership's floor plan loan,

which was utilized to purchase automobiles from the manufacturer

for inventory purposes. Three years later, petitioner’s assets

were used to make a $400,000 payment to Sanwa Bank to fulfill the

guaranty obligation, which petitioner deducted as a business bad

debt. Respondent contends that the bad debt is a nonbusiness bad

debt and may not, therefore, be used to generally reduce ordinary

income. In other words, respondent determined that petitioner is

entitled to a short-term capital loss, and petitioner bears the

burden of establishing that respondent's determination is

erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933). Also, deductions are a matter of legislative grace, and

petitioner has the burden of proving his entitlement to the

claimed deductions. See New Colonial Ice Co. v. Helvering, 292

U.S. 435, 440 (1934).
 - 20 -

Generally, section 166(a) provides that a taxpayer may

deduct a bad debt in full in the year it becomes worthless.

Under section 166, worthless business bad debts are fully

deductible from ordinary income. On the other hand, worthless

nonbusiness bad debts are treated as short-term capital losses.

Secs. 166(d)(1)(B), 1222(2). A nonbusiness bad debt is defined

in section 166(d)(2) as a debt other than:

(A) a debt created or acquired (as the case may
be) in connection with a trade or business of the
taxpayer; or

(B) a debt the loss from the worthlessness of
which is incurred in the taxpayer's trade or business.

When a taxpayer guarantees a debt in the course of his trade

or business, payment of part or all of the taxpayer's obligations

as guarantor is treated as a business bad debt in the taxable

year in which the payment is made (assuming the taxpayer's right

of subrogation against the debtor is worthless). If the

guarantee was made in the course of the taxpayer's trade or

business, the loss can be used to reduce ordinary income in the

year of payment. Sec. 1.166-9(a), Income Tax Regs. However, if

the agreement guaranteeing the debt was entered into for profit,

but not in the course of the taxpayer's trade or business, the

loss is a short-term capital loss in the year in which the

guarantor pays the debt. Weber v. Commissioner, T.C. Memo. 1994-

341; Smartt v. Commissioner, T.C. Memo. 1993-65; Brooks v.

Commissioner, T.C. Memo. 1990-259; sec. 1.166-9(b), Income Tax
 - 21 -

Regs. Whether a taxpayer is engaged in a trade or business is a

question of fact. United States v. Generes, 405 U.S. 93, 104

(1972); sec. 1.166-5(b), Income Tax Regs.

To obtain a business bad-debt deduction, the taxpayer must

establish that (1) he was engaged in a trade or business, and

(2) the acquisition or worthlessness of the debt was proximately

related to the conduct of such trade or business. Putoma Corp.

v. Commissioner, 66 T.C. 652 (1976), affd. 601 F.2d 734 (5th Cir.

1979); sec. 1.166-5(b), Income Tax Regs. Whether a particular

guaranty is proximately related to the taxpayer's trade or

business depends upon the taxpayer's dominant motivation for

becoming a guarantor. United States v. Generes, supra at 104;

Harsha v. United States, 590 F.2d 884 (10th Cir. 1979); French v.

United States, 487 F.2d 1246 (1st Cir. 1973); Stoody v.

Commissioner, 66 T.C. 710 (1976), vacated on another issue 67

T.C. 643 (1977); Weber v. Commissioner, T.C. Memo. 1994-307;

Smartt v. Commissioner, supra.

In determining whether the taxpayer's dominant motivation

was to protect his salary or to protect his investment, the

Courts have compared the taxpayer's salary, the value of his

investment, and other motivating factors at the time he

guaranteed the loan. United States v. Generes, supra at 106;

Putoma Corp. v. Commissioner, supra at 674 n.32; Schwartz v.

Commissioner, T.C. Memo. 1995-415; Garner v. Commissioner, T.C.
 - 22 -

Memo. 1991-569, affd. 987 F.2d 267 (5th Cir. 1993).5 Also, we

may examine how the taxpayer would have benefited from the loan

or guarantee had the loan not gone bad. Tennessee Sec., Inc. v.

Commissioner, 674 F.2d 570, 574 (6th Cir. 1982), affg. T.C. Memo.

1978-434. Finally, in determining the taxpayer's dominant

motivation, objective facts take precedence over unsupported

statements of subjective intent. Kelson v. United States, 503

F.2d 1291 (10th Cir. 1974).

When a guarantor of a corporate debt is a shareholder and

also an employee, mixed motives for the guaranty are often

present, and the critical issue becomes which motive is dominant.

United States v. Generes, supra at 100. "[I]nvesting is not a

trade or business". Whipple v. Commissioner, 373 U.S. 193, 202

(1963). An employee's motive for guaranteeing a loan may be to

5
The Court of Appeals for the Fifth Circuit stated:

Generes and its progeny have established objective
criteria to aid courts in their search [for dominant
motive]. Our investigation centers around three
factors: the size of the taxpayer's investment, the
size of his after-tax salary, and the other sources of
gross income available to the taxpayer at the time of
the guarantees. [Garner v. Commissioner, 987 F.2d 267,
270 (5th Cir. 1993); affg. T.C. Memo. 1991-569;
citation omitted.]

The Court of Appeals for the Ninth Circuit stated generally
that Generes stood for the proposition that the proper
characterization of a worthless debt as "business" or
"nonbusiness" was a question of fact to be established by the
individual circumstances of each case. Hunsaker v. Commissioner,
615 F.2d 1253, 1256 nn.3 & 4 (9th Cir. 1980).
 - 23 -

protect one's employment or salary. Weber v. Commissioner, T.C.

Memo. 1994-341. "[I]t must be clear from the record that the

primary reason for making the advances which gave rise to the

debts was business related rather than investment related".

Smith v. Commissioner, 60 T.C. 316, 319 (1973).

Generally, returns from investing result from appreciation

and earnings on the investment rather than from personal effort

or labor. United States v. Generes, supra at 100-101.

Conversely, one's role or status as an employee is a business

interest. It typically involves the exertion of effort and labor

in exchange for a salary. Id.; see also Litwin v. United States,

983 F.2d 997 (10th Cir. 1993); Smartt v. Commissioner, supra.

If the dominant motive was to increase the value of

petitioner's stock in the auto dealership, then the loan was a

nonbusiness investment. If the dominant motive was to increase

or protect the taxpayer's salary, then the loan was a business

debt. If both outcomes occurred, then a consideration of all of

the relevant facts, emphasizing the objective factors and giving

controlling weight to no one single factor (the Generes

approach), should be utilized. Litwin v. United States, supra;

Smartt v. Commissioner, supra.

Respondent has conceded that the $400,000 business bad-debt

deduction claimed on petitioner's 1990 Federal income tax return

arises from the $400,000 payment on the floor plan loan, which is
 - 24 -

separate and distinct from any other $400,000 amount; i.e., the

cap loan and the contributions, separately. Respondent also

concedes that petitioner was in the business of being an auto

dealership employee. However, respondent does not agree that

petitioner's dominant motive at the time of the guarantee was

related to any trade or business. Respondent argues that the

guarantee was made to protect petitioner's investment in the auto

dealership.

A related issue concerns the appropriate timeframe within

which to measure petitioner's motivation in guaranteeing the

floor plan loan. Respondent asserts that petitioner's dominant

motivation should be measured from the time when he last

negotiated for an extension and personally guaranteed an

extension for the floor plan loan in October 1989. Petitioner

contends that the correct time was when the business opened in

March 1987.

Generally, a taxpayer's motivation is determined as of the

date upon which the taxpayer made the guarantee rather than the

date upon which a payment in discharge of liability as guarantor

is made. Harsha v. United States, supra; French v. United

States, supra; Smartt v. Commissioner, T.C. Memo. 1993-65.

Specifically, the focus of inquiry on a taxpayer's dominant

motivation is at the time the taxpayer incurs the obligation, not
 - 25 -

when the payment is made. French v. United States, supra at

1248; Smartt v. Commissioner, supra; Modell v. Commissioner, T.C.

Memo. 1983-761; Cho v. Commissioner, T.C. Memo. 1976-318.6

Petitioner personally guaranteed payment of the entire floor plan

loan as early as July 31, 1988. The last record of an extension

of the guarantee, on October 15, 1989, however, reflects that

petitioner signed a promissory note to extend the floor plan loan

to December 1, 1989. We are unable to view the extension(s) of

the guarantee as a new commitment. As its nomenclature

indicates, an "extension" merely continues the original

obligation. Thus, petitioner's motivation with respect to the

floor plan arrangement is measured as of July 31, 1988.

1. Petitioner's Investment--Petitioner owned all the

outstanding stock of the corporate dealership. His total

contribution was composed of two amounts each approximating

$400,000. The first $400,000 was comprised of petitioner's

liquid assets of $250,000 and a $150,000 note.

In attempting to minimize the relative size of his

investment in the dealership, petitioner argues that it would not

6

The statute and the regulations do not
tell us at what point in time we should look
to determine proximity in a guaranty context.
* * * [Case precedent holds] that the time to
determine proximity is the time when
petitioner entered into his guarantee
agreements. [Cho v. Commissioner, T.C. Memo.
1976-318.]
 - 26 -

have been reasonable for him to make multimillion dollar

guarantees to protect a $250,000 cash investment. Also, he

argues that his salary from his auto dealership matched his out-

of-pocket contributions. This contention misconstrues

petitioner's stake in the auto dealership. Focusing on the

second $400,000 component of the $806,000, the cap loan,

petitioner contends that he did not individually borrow that

amount from Sanwa Bank. The record, however, reflects that on

July 9, 1986, Sanwa Bank notified petitioner that he was approved

for the cap loan. In that letter, petitioner is denominated

"borrower" and the auto dealership "guarantor". Also, in the

March 2, 1987, business loan agreement, petitioner is again shown

as the borrower. Sanwa Bank's corporate resolution confirming

the parties' intentions regarding the cap loan also shows

petitioner as borrower.

The two guaranty extension documents reflect Sanwa Bank's

intention to hold petitioner personally liable for the cap loan.

Although one of the documents shows petitioner as guarantor, the

sequence of events and documents demonstrate that the original

guaranty was in error, and, in due time, was corrected. We also

note that petitioner deposited the proceeds of the cap loan in

his personal bank account and disbursed from that account the

moneys to the auto dealership, thereby exercising dominion and

control over the loan proceeds.
 - 27 -

Moreover, by securing the cap loan, petitioner was able to

raise the money necessary for the opening of the auto dealership.

Thus, in total, petitioner personally contributed approximately

$806,000 to the auto dealership. This investment was substantial

in nature.

At the inception of the auto dealership, petitioner secured

a $2.5 million floor plan arrangement to acquire inventory

(automobiles). Initially, petitioner was not required to

personally guarantee the floor plan arrangement. It was not

until July 31, 1988, that petitioner personally guaranteed the

floor plan loan. By that time, the floor plan amount had

increased significantly, permitting the auto dealership to have

an expanded inventory base.

The record, generally, reflects that petitioner's dominant

motivation was as an investor. His motivation in guaranteeing

the floor plan loan was to protect his investment in the business

of the auto dealership, as opposed to protecting his trade or

business as an employee.

Finally, in 1989, Sanwa Bank was concerned that the floor

plan amount was "out of trust" and requested that petitioner

decrease the outstanding loan. In the process, Sanwa Bank

received a $400,000 security interest in petitioner's home.

Sanwa Bank received $400,000 from the March 2, 1990, sale

proceeds from petitioner's home. Again, petitioner's dominant
 - 28 -

motivation was to protect his equity investment in the auto

dealership. Without the floor plan loan, petitioner's auto

dealership would have been critically impaired. See Tennessee

Sec., Inc. v. Commissioner, 674 F.2d at 574.

Overall, petitioner invested and assumed liabilities of

almost $700,000 and guaranteed several million dollars worth of

inventory. In contrast, his total salary over the same 4 years

was $893,833. In addition, petitioner remained liable for the

$1.1 million debt due Sanwa Bank after the foreclosure. These

figures contradict petitioner's argument that his total salary

comported with his exposure to liabilities.

2. Petitioner's Salary--Petitioner contends that he was

apprehensive about his position in Robertson Honda because his

salary was higher than comparable general managers, motivating

him to acquire an automobile dealership. Although petitioner

stated his beliefs as to general managers' salaries, no

comparable salaries of general managers were offered. Also,

petitioner had an "excellent" working relationship with the owner

of Robertson Honda, who assisted petitioner in obtaining an Acura

dealership franchise. These factors undermine petitioner's

contentions about the precarious nature of his salary and tenure

with Robertson Honda.

Petitioner asserts that he expected to make a salary ranging

from $750,000 to $3 million. His salary speculations were more
 - 29 -

anecdotal than factual. We note that petitioner did not offer

Robertson's testimony or that of other auto dealers.

Petitioner did offer the testimony of Ms. Rugh, the auto

dealership's accountant. Ms. Rugh thought petitioner's salary

was low when compared to other auto dealers with which she was

familiar. Petitioner, however, did not provide a plausible

explanation as to why his salaries were substantially less than

he testified others were, especially considering the exclusivity

of his auto dealership's geographic market (the San Fernando

Valley) for the first 2 years. In that regard, petitioner's auto

dealership was the number one Acura dealership in the nation for

its first 2 years.

Finally, subsequent to the foreclosure of the auto

dealership, petitioner's salary level working for other

dealerships was comparable to his earnings when he worked for his

own dealership. Accordingly, petitioner knew that with his

experience and background in the automobile sales field, he would

be able to obtain employment and commensurate levels of

compensation elsewhere.

3. Other Factors--During the first 2 years, petitioner's

business was the number one Acura dealership in the country. His

auto dealership demonstrated, generally, increases in gross

receipts of $7,414,704, gross profits of $577,060, and total

income of $594,819 in 1988 compared to the year before. Despite
 - 30 -

these increases, petitioner received a salary of $180,000 in 1988

compared with $516,232.65 in 1987. In spite of increased gross

profits for 1988 and 1989, petitioner's salary declined from

$180,000 in 1988 to $152,400 in 1989. There is no indication

that there was any limitation on petitioner's ability to pay

himself a salary. He was the sole owner and submitted a business

plan to American Honda.

This salary pattern suggests that petitioner wanted to

protect his equity interest. We hold that petitioner expected

returns primarily from appreciation and earnings on his

investment rather than in the form of salary from personal effort

or labor on his part. United States v. Generes, 405 U.S. at 100-

101. Accordingly, if the auto dealership were successful,

petitioner's reward would be realized primarily through sale or

other disposition of his stock interest, rather than his salary.

Putoma Corp. v. Commissioner, 66 T.C. at 674.

Accordingly, petitioner's dominant motive in paying amounts

pursuant to his guaranty of the floor plan loan was to protect

his investment in the dealership and, accordingly, the resulting

loss was capital in nature, deductible only as a nonbusiness bad

debt.

Accuracy-Related Penalty Under Section 6662(a)

Respondent determined that petitioner was liable for the

accuracy-related penalty pursuant to section 6662(a). Section
 - 31 -

6662(a) provides a penalty equal to 20 percent of the portion of

the underpayment, in this case, that is attributable to

negligence or disregard of the rules or regulations. Sec.

6662(a) and (b)(1). The burden is on the taxpayer to show a lack

of negligence. Rule 142(a); Bixby v. Commissioner, 58 T.C. 757,

791-792 (1972).

Negligence is defined as the failure to exercise the due

care that a reasonable and ordinarily prudent person would employ

under the circumstances. Neely v. Commissioner, 85 T.C. 934, 947

(1985). The question is whether a particular taxpayer's actions

in connection with the transactions were reasonable in light of

his experience and the nature of the investment or business. See

Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 740 (1973).

When considering the question of negligence, we evaluate the

particular facts of each case, judging the relative

sophistication of the taxpayers, as well as the manner in which

they approached their transactions and reporting position.

McPike v. Commissioner, T.C. Memo. 1996-46.

A taxpayer may avoid liability for negligence by relying on

competent professional advice, if it was reasonable to rely on

such advice. United States v. Boyle, 469 U.S. 241, 250-251

(1985); Freytag v. Commissioner, 89 T.C. 849, 888 (1987), affd.

904 F.2d 1011, 1017 (5th Cir. 1990), affd. 501 U.S. 868 (1991).

Reliance on professional advice, standing alone, is not an
 - 32 -

absolute defense to negligence, but rather a factor to be

considered. In order for reliance on professional advice to

excuse a taxpayer from the additions to tax for negligence, the

taxpayer must show that such professional had the expertise and

knowledge of the pertinent facts to provide valuable and

dependable advice on the subject matter. Goldman v.

Commissioner, 39 F.3d 402, 408 (2d Cir. 1994), affg. T.C. Memo.

1993-480; Freytag v. Commissioner, supra; Kozlowski v.

Commissioner, T.C. Memo. 1993-430, affd. without published

opinion 70 F.3d 1279 (9th Cir. 1995).

Whether petitioner properly deducted the $400,000 involves a

complex factual inquiry. When a guarantor of a corporate debt is

a shareholder and also an employee, mixed motives for a guaranty

may be present, and the critical issue becomes, in an objective

sense, which motive is dominant. United States v. Generes, 405

U.S. at 100.

In addition, petitioner's accountant, who maintained

adequate books and records for petitioner, agreed with his

treatment of the losses. Petitioner, on his 1990 Federal income

tax return, reported that he was deducting $400,000 in capital

losses on his Schedule D. This stems from petitioner's cap loan.

The record also reflects that on petitioner's 1990 Schedule C, he

reported $400,000 in losses pursuant to "personal guarante [sic]

of loan from corporation".
 - 33 -

We hold petitioner was reasonable in his reliance on

advisers and in his reporting position, and, accordingly, he is

not liable for the accuracy-related penalty under section 6662(a)

for the 1990 taxable year.

To reflect the foregoing and due to concessions,

Decision will be entered

under Rule 155.