Elliott v. Commissioner

T.C. Memo. 1997-294

UNITED STATES TAX COURT

HERBERT C. ELLIOTT, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 23599-95. Filed June 26, 1997.

John H. Trader, for petitioner.

Dennis R. Onnen, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: Herbert C. Elliott petitioned the Court to

redetermine respondent's determination with respect to his 1991
 - 2 -

and 1992 taxable years. Respondent determined the following

income tax deficiencies and penalties for those years:

Penalty
Sec.
Year Deficiency 6662(a)

1991 $25,105 $5,021
1992 9,917 1,983

We must decide whether section 166 allows petitioner to

deduct the $50,000, $47,350, $31,000, $12,000, and $5,000 amounts

discussed below as worthless business debts. We hold it does

not. We also decide whether petitioner is liable for the

penalties determined by respondent under section 6662(a) for

substantial understatement of income tax. We hold he is not.

Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the years in issue. Rule

references are to the Tax Court Rules of Practice and Procedure.

Dollar amounts are rounded to the nearest dollar.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulated facts and exhibits submitted therewith are

incorporated herein by this reference. Petitioner resided in

Kansas City, Missouri, when he petitioned the Court. He filed

for each of the years 1991 and 1992 a Form 1040, U.S. Individual

Income Tax Return, using the filing status of "Single". These

returns were prepared by petitioner's counsel, John H. Trader.

Petitioner relied on Mr. Trader to prepare his returns correctly.
 - 3 -

Petitioner is a painter by trade. He quit school after the

eighth grade, and he began painting in 1951 as an apprentice.

He started his own painting company in 1963, and he has either

managed or comanaged his businesses since that time, performing

all functions of an entrepreneur including marketing his services

and supervising his employees. During the relevant time, he

owned 90 percent of the stock of Elliott Painting Co. (EPC),

which he had organized in 1972 to incorporate his painting

business, and he was EPC's president, one of its directors, and

one of its employees. EPC filed for bankruptcy and went out of

business in 1985. The bankruptcy court closed the case in

November 1988.

On August 12, 1983, Kansas American Bank (the Bank) lent EPC

$500,000 (the Loan). The Loan was guaranteed by the U.S. Small

Business Administration (SBA) and by petitioner, both personally

and in his capacity as president of Electro-Magnetic Refinishers,

Inc. (EMR), a corporation in which he owned 39 percent of its

stock. In connection with the Loan, petitioner, in his capacity

as EPC's president, signed a $500,000 note drafted on an SBA form

and bearing an SBA loan number, and EPC gave the Bank a security

interest in EPC's accounts receivable, inventory, machinery,

equipment, and furniture and fixtures. At the behest of the

Bank, petitioner, in the names of "Herbert Elliott", "Herbert E.

Elliott", and "Herbert C. Elliott", also personally signed a

$500,000 note (Petitioner's Note) and a deed of trust on three
 - 4 -

tracts of his land to secure EPC's obligation under the Loan.

Petitioner's Note contained a legend that stated:

This note is secured by a Deed of Trust of even date,
and this note and Deed of Trust are given to secure the
makers obligation under a note dated August 12, 1983,
given by makers to Kansas American Bank for the benefit
of Herbert Elliott, a/ka Herbert E. Elliott, a/k/a
Herbert C. Elliott; together with and including any
other obligations of the Makers to Kansas American Bank
whether now existing or originating hereafter and this
note does not create an additional indebtedness of its
makers to said Bank.[1]

EPC used $317,051 of the $500,000 in Loan proceeds to pay off a

debt owed to the Bank, and EPC used the rest of the proceeds for

working capital. Petitioner expected EPC's business to prosper

as a result of the Loan, and he expected that the value of his

EPC stock would increase. Among other things, EPC's receipt of

the Loan proceeds allowed it to secure larger jobs.

The Loan went into default sometime in 1984. Before then,

EPC had made all payments on the Loan directly to the Bank. On

March 29, 1985, when the balance of the Loan was approximately

$481,467, the Bank assigned the Loan (including the related

security and guaranties) to the SBA.2 The SBA foreclosed on the

mortgage of petitioner in which it held a security interest, and,

in October 1991, the SBA accepted an offer by petitioner to

1
Petitioner's Note does not define the term "makers" in
either the small or capital case.
2
On Mar. 12, 1985, EPC owed $478,380 on the Loan (principal
of $447,910 and interest of $30,470), and interest continued to
accrue at 13 percent per annum. We do not find that any payments
were made on the Loan between Mar. 12 and Mar. 29, 1985.
 - 5 -

settle his liability on the Loan for $12,000. Petitioner paid

the $12,000 to the SBA in October 1991 in complete satisfaction

of his liability on the Loan.

In the same month, petitioner paid $5,000 to Fidelity &

Deposit Co. of Maryland (F&D), a company that wrote contract

surety bonds on behalf of EPC, to satisfy his liability to F&D.

On or about December 9, 1982, petitioner had agreed to indemnify

F&D for any surety bonds that it wrote on behalf of EPC, and F&D

had paid $5,000 in 1991 to complete a job which EPC had been

required, but failed, to complete. Petitioner had agreed to

indemnify F&D so that EPC could secure larger jobs. Petitioner

deducted his $5,000 payment to F&D on his 1991 return as a

business bad debt. In the notice of deficiency, respondent

reflected his determination that the payment was deductible as a

nonbusiness bad debt and that petitioner was allowed $3,000 of

this deduction in 1991 and $2,000 in 1992.

EPC had unpaid payroll tax liabilities (reportable on

Form 941, Employer's Quarterly Federal Tax Return) for the fourth

quarter of 1983, the first and fourth quarters of 1984, and the

first quarter of 1985. On July 14, 1986, the Commissioner

assessed against petitioner the trust fund portions of those

liabilities under the authority of section 6672. The assessed

amount equaled $107,006. Eight months later, the Commissioner

assessed against petitioner a trust fund recovery penalty under

the authority of section 6672 with respect to payroll tax
 - 6 -

liabilities of EMR for the fourth quarter of 1983, the first and

fourth quarters of 1984, and the first and second quarters of

1985. This assessed amount equaled $42,407.

Petitioner paid $18 with respect to the EPC liabilities and

$88 with respect to the EMR liabilities, and he sued the United

States on or about September 19, 1989, for a refund of these

payments. The United States conceded that petitioner was not

liable for the penalty with respect to EMR for the first and

second quarters of 1985 and that the penalty with respect to EMR

for the fourth quarter of 1984 was $4,927. In an order filed

May 28, 1991, the District Court hearing the case ruled that

petitioner also was not liable for the penalty with respect to

EMR for the fourth quarter of 1983 and the first quarter of 1984.

Thus, the total penalty against petitioner with respect to EMR

was reduced to $4,927.

On April 16, 1991, petitioner offered to settle the two

refund cases for $31,000. One month later, the United States

accepted his offer, and, in the next month, petitioner paid the

United States $31,000 in complete satisfaction of his liability

under section 6672. The United States applied petitioner's

payment to the $107,006 penalty assessed against him with respect

to the EPC liabilities. Petitioner had not designated any part

of the payment as interest, and the United States did not apply

any part of the payment to interest.
 - 7 -

Petitioner reported on his 1991 and 1992 tax returns that he

was entitled to deduct losses under section 1244 of $50,000 and

$47,350, respectively, on the theory that the Bank lent him the

$500,000, that he contributed the $500,000 to EPC's capital, and

that his contribution became worthless in 1988. Petitioner's

1991 and 1992 tax returns included a Form 8275, Disclosure

Statement, and an attachment thereto, that set forth the facts of

his theory as well as his position on the deductibility of the

amounts under section 1244. Petitioner's 1991 Form 8275 and

attachment thereto also revealed the facts concerning the

$31,000, $12,000, and $5,000 amounts at issue herein and his

position on the deductibility of these amounts, which he claimed

as business bad debt deductions on the 1991 return. Petitioner's

position on these latter amounts, as stated in his 1991 return,

is the same position that petitioner takes in the instant

proceeding.

Petitioner's Federal income tax returns report that he

earned personal service income for every year following and

including the year of the Loan. In 1991 and 1992, petitioner

worked as an employee of Elliott Drywall & Asbestos, Inc., and he

was paid compensation of $73,000 and $52,000 during the

respective years.

OPINION

Petitioner must prove that respondent's determinations set

forth in the notice of deficiency are incorrect. Rule 142(a);
 - 8 -

Welch v. Helvering, 290 U.S. 111, 115 (1933). Petitioner also

must prove his entitlement to the disputed deductions.

Deductions are a matter of legislative grace. New Colonial Ice

Co. v. Helvering, 292 U.S. 435, 440 (1934).

1. $50,000 and $47,350 Amounts

Petitioner claimed on his 1991 and 1992 Forms 1040 that he

was entitled to deduct $50,000 and $47,350, respectively, under

section 1244. Petitioner has abandoned this claim and now claims

that he may deduct these amounts as business bad debts under

section 166. Petitioner contends that the Bank lent him the

$500,000 at issue, and that he lent this amount to EPC mainly to

secure income that it was paying him as rent and salary.

Petitioner concludes that the cessation of EPC caused its debt to

him to become worthless, triggering his entitlement to a business

bad debt deduction. Petitioner concedes that he has no written

documentation to support his claim of a loan to EPC but states

that he regularly lent money to EPC in this manner.

Respondent determined that petitioner was not allowed to

deduct either the $50,000 or the $47,350 amount. According to

respondent, the Bank lent the money to EPC. Respondent conceded

at trial that petitioner is entitled to deduct a $12,000

nonbusiness bad debt for the amount that he paid the SBA to

satisfy his liability on the Loan.

We agree with respondent. We have found as a fact that the

Bank lent the $500,000 to EPC, and we read the record as having
 - 9 -

ample support for this finding. In support of his assertion that

the Bank lent the funds to him, petitioner focuses primarily on

Petitioner's Note and asserts that this note establishes that he

was primarily liable for the repayment of the Loan. We disagree.

We read Petitioner's Note to be nothing more than another form of

security required by the Bank as a precondition to making the

$500,000 loan to EPC. In addition to the fact that Petitioner's

Note stated specifically that it did not create a separate

indebtedness, we read Petitioner's Note as well as every other

document connected with the Loan to state clearly that EPC was

the debtor and that petitioner was a guarantor. Nor do we find

anything in the record to persuade us that petitioner and EPC had

a debtor/creditor relationship during the relevant year. As a

point of fact, EPC's 1982 and 1983 Form 1120, U.S. Corporation

Income Tax Return, stated explicitly that neither EPC nor

petitioner owed the other anything during the period from

September 1, 1982, through August 31, 1984. We conclude, as we

have found, that the Bank made the Loan to EPC, and that

petitioner guaranteed the Loan.

With this conclusion in mind, we turn to the income tax

consequences that flow from petitioner's position as a guarantor.

A guarantor may deduct a debt that he or she guaranteed when the

guarantor's liability for the debt is certain and he or she

actually pays it. See Helvering v. Price, 309 U.S. 409 (1940);

Eckert v. Burnet, 283 U.S. 140 (1931). If the guarantor
 - 10 -

guaranteed the debt in the course of his or her trade or

business, payments on the guaranty are treated as a business bad

debt at the time of payment if the guarantor's right of

subrogation against the debtor is then worthless. In such a

case, the bad debt is an ordinary deduction that may offset

ordinary income. Sec. 1.166-9(a), Income Tax Regs. If, on the

other hand, the guarantor guaranteed the debt in the course of a

transaction entered into by the guarantor for profit, and not in

the course of his or her trade or business, the bad debt is a

short-term capital loss realized when paid, and the recognition

of it is subject to the limitations of section 1211. See

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 Regs.

A guarantor is entitled to a business bad debt deduction for

a guaranteed debt that he or she pays when the guarantor proves

that: (1) He or she was engaged in a trade or business at the

time of the guaranty and (2) the guaranty was proximately related

to the conduct of that trade or business. See 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 the guarantor

is engaged in a trade or business is factual. United States v.

Generes, 405 U.S. 93, 104 (1972); sec. 1.166-5(b), Income Tax

Regs. Whether a guaranty is proximately related to the

guarantor's trade or business rests on his or her dominant
 - 11 -

motive, at the time of the guaranty, 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); Weber v. Commissioner, supra; Smartt v.

Commissioner, supra. When a guarantor of a corporate debt is a

shareholder of the corporation, as well as one of its employees,

mixed motives for the guaranty are usually present, and the

critical fact is which motive is dominant. United States v.

Generes, supra at 100. The dominant motive must be business

related, as opposed to investment related, for a guaranty to be

business related. See Smith v. Commissioner, 60 T.C. 316, 319

(1973). A motive is business related when the guarantor aims to

increase or protect his or her salary from the debtor

corporation. A motive is investment related when the guarantor

aims to increase or protect the value of his or her stock in the

debtor corporation. See Weber v. Commissioner, supra. Objective

facts weigh more heavily then the guarantor's unsupported

statements of subjective intent in measuring his or her motive.

Kelson v. United States, 503 F.2d 1291 (10th Cir. 1974).

Following our detailed review of the record, we are not

persuaded that petitioner's dominant motive in guaranteeing the

Loan was business related. Indeed, we read the record to point

to the opposite conclusion. Petitioner testified that he

expected EPC's business to prosper as a result of the Loan, and

that this, in turn, would increase the value of his EPC stock.
 - 12 -

Petitioner also has generated large amounts of personal service

income in years following and including the year of the Loan, and

we do not find that petitioner's guaranty of the Loan was tied to

his receipt of this income. We hold that petitioner's dominant

motive when he guaranteed the Loan was to protect his investment

in EPC, and, hence, that his deduction with respect thereto is

attributable to a nonbusiness bad debt.

As to the amount of petitioner's deduction, we find that

petitioner paid the Bank $12,000, and that it foreclosed on his

land that he pledged as security for the Loan. We decline to

allow petitioner any deduction with respect to the land. The

parties have not adequately addressed the tax consequences

surrounding the SBA's foreclosure of the mortgage, and the record

does not contain enough data for us to determine the tax

consequences, including petitioner's deduction (if any), with

respect thereto. See Helvering v. Hammel, 311 U.S. 504 (1941)

(a foreclosure is a "sale" precipitating the recognition of gain

or loss). We are unable to find, for example, the value of the

land at the time of the foreclosure, the amount realized by

petitioner upon the foreclosure, or petitioner's basis in the

land at the time of the foreclosure. Accordingly, we hold that

petitioner's deduction is limited to $12,000.

2. $31,000 Amount

Respondent also determined that petitioner could not deduct

the $31,000 payment that he made to the United States in 1991.
 - 13 -

Petitioner claims that this payment is deductible as a business

bad debt mainly because EPC's articles of incorporation provided

that it would indemnify him for this payment and EPC failed to do

so. We disagree. Petitioner is not entitled to deduct any

portion of this amount. Even if we were to assume that EPC was

required to indemnify petitioner for this payment, an assumption

which we do not find as a fact, petitioner would be unable to

deduct this amount because he paid it in settlement of amounts

assessed against him under section 6672. Amounts paid for

section 6672 assessments are nondeductible. See sec. 162(f);

sec 1.162-21(b), Income Tax Regs; see also Arrigoni v.

Commissioner, 73 T.C. 792 (1980); Patton v. Commissioner, 71 T.C.

389 (1978); Smith v. Commissioner, 34 T.C. 1100 (1960), affd. per

curiam 294 F.2d 957 (5th Cir. 1961); Duncan v. Commissioner,

T.C. Memo. 1993-370, affd. 68 F.3d 315 (9th Cir. 1995).

Petitioner argues that the law is different because he had a

right of indemnification from EPC. We disagree. As the Court

stated in Arrigoni v. Commissioner, supra at 801 n.9, in

rejecting a similar claim:

even if a right to reimbursement exists, petitioners
would still fail on their claim. Sec. 162(f) makes the
addition to tax imposed by sec. 6672 nondeductible.
Patton v. Commissioner, 71 T.C. 389 (1978). Since the
addition to tax imposed by sec. 6672 is personal to the
taxpayer, petitioners cannot invoke sec. 166 to
circumvent the prohibition of a deduction under sec.
162(f). Cf. Smith v. Commissioner, 34 T.C. 1100
(1960), affd. per curiam 294 F.2d 957 (5th Cir. 1961).
The deductibility of the payments must be treated in a
manner consistent with the proper treatment of the
 - 14 -

underlying obligation. Rude v. Commissioner, 48 T.C.
165 (1967). This Court will not permit the taxpayer to
transform a nondeductible personal obligation into a
deductible corporate debt when to do so would
circumvent the effectiveness of sec. 6672. But see
First Natl. Bank of Duncanville v. United States, * * *
[481 F. Supp. 633 (N.D. Tex. 1979)].

We hold for respondent on this issue.

3. $12,000 and $5,000 Amounts

Petitioner argues he is entitled to deduct the $12,000 and

$5,000 amounts as business bad debts because the deductions arose

from actions that he had taken to secure the receipt of his

earnings from EPC. Respondent concedes that both amounts are

deductible as nonbusiness bad debts.

We agree with respondent. We have previously addressed and

rejected petitioner's claim concerning the $12,000 amount,

holding that he may deduct this amount as a nonbusiness bad debt.

For the same reasons that pertain thereto, we hold likewise with

respect to the $5,000 amount. Petitioner has failed to persuade

us that he incurred the $5,000 debt for reasons other than

investment.

4. Applicability of Accuracy-Related Penalty

Respondent determined that petitioner was liable for an

accuracy-related penalty under section 6662(a) for each year

because he substantially understated his income tax. See sec.

6662(d). As applicable herein, section 6662(a) imposes an

accuracy-related penalty equal to 20 percent of the portion of an

underpayment that is attributable to substantial understatement.
 - 15 -

Petitioner must prove that respondent erred in determining that

the accuracy-related penalty applied to the instant years. Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); see also

Allen v. Commissioner, 925 F.2d 348, 353 (9th Cir. 1991), affg.

92 T.C. 1 (1989); Bixby v. Commissioner, 58 T.C. 757, 791-792

(1972). Respondent erred if petitioner's understatement did not

exceed the greater of 10 percent of the tax required to be shown

on the return or $5,000. See sec. 6662(d)(1). For this purpose,

an amount was not understated to the extent it was based on

substantial authority or adequately disclosed in the return or in

a statement attached to the return. Sec. 6662(d)(2)(B).

We disagree with respondent that petitioner was subject to

an accuracy-related penalty in either of the years at issue. We

look to petitioner's 1991 and 1992 tax returns, and we find that

petitioner disclosed adequately the relevant facts of his

treatment of the $50,000 and $47,350 deductions.3 Respondent

argues that petitioner's disclosure is inadequate because he

relied on section 1244 to exclude these amounts from his gross

income, and he has abandoned that position in this proceeding.

We disagree. The test of adequate disclosure does not rest

solely on whether a taxpayer has identified the correct section

of the Code to support a reported deduction. What is critical is

3
We also note that the carryover arose from a purported
loss in 1988, and that petitioner made a similar disclosure on
his 1988 Form 1040.
 - 16 -

whether the taxpayer adequately disclosed enough relevant data

concerning the treatment of the item to alert the Commissioner to

a potential controversy. See Estate of Reinke v. Commissioner,

46 F.3d 760 (8th Cir. 1995), affg. T.C. Memo. 1993-197; Schirmer

v. Commissioner, 89 T.C. 277, 285-286 (1987). We find from

petitioner's returns that such was the case.

Respondent also asserts that the adequate disclosure test is

inapplicable because petitioner did not have a reasonable basis

to sustain his position. We disagree. We do not believe that

petitioner's position was unreasonable. Petitioner has an eighth

grade education, and, under the facts herein, we believe that it

was reasonable for him to rely on Mr. Trader's preparation of his

tax returns. Inasmuch as the other disputed amounts were also

disclosed similarly, we hold for petitioner on this issue.

In reaching our holdings herein, we have considered all

arguments made by the parties for contrary holdings and, to the

extent not discussed above, find them to be irrelevant or without

merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.