Peterson v. Commissioner

T.C. Memo. 1997-377

UNITED STATES TAX COURT

GLENN AND MARION PETERSON, Petitioners v. COMMISSIONER OF
INTERNAL REVENUE, Respondent

Docket No. 4736-95. Filed August 19, 1997.

Glenn and Marion Peterson, pro sese.

Mark Hulse, for respondent.

MEMORANDUM OPINION

TANNENWALD, Judge: Respondent determined the following

deficiencies and additions to tax and a penalty in petitioners'

Federal income taxes:

Year Deficiencies Additions and Penalty
Sec. 6651 Sec. 6653 Sec. 6662

1988 $ 3,868 --- $193 ---
1989 $12,366 $1,378 --- $2,473
 - 2 -

After concessions by the parties, the issue for decision is

whether petitioners may take a business bad debt deduction for

payment made on a guarantee of corporate indebtedness.

Background

This case was submitted fully stipulated under Rule 122.1

The stipulation of facts and exhibits are incorporated herein by

this reference and found accordingly.

Petitioners, husband and wife, resided in Syosset, New York,

at the time of the filing of the petition. They filed their 1988

Federal income tax return untimely on April 17, 1992, and their

1989 Federal income tax return untimely on April 15, 1993. On

January 12, 1995, respondent mailed to petitioners a statutory

notice of deficiency for the 1988 and 1989 taxable years.

Dutchess Processing Company, Inc. (Dutchess), was

incorporated in August 1974, to engage in the processing,

preserving, and canning of apples and apple byproducts. Its

shareholders and officers were petitioner Glenn Peterson, his

father John Peterson, and Woodrow Pereira.2

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
2
The stipulation of facts refers only to the status of
these individuals as officers, but petitioners' opening brief
describes them as the "three shareholders" who were "all active
(continued...)
 - 3 -

From October 1974 until May 1975, one of Dutchess' principal

customers, to which it sold processed apples, was Entenmann's

Bakery, located in Bay Shore, New York. Dutchess did not grow

its own apples. It purchased apples from United Apple Co.,

Agway, Inc. (Agway), located in Syracuse, New York, and local

independent growers. Agway was a primary supplier to Dutchess.

Dutchess was undercapitalized and could purchase apples from

Agway only on credit. Agway required Glenn Peterson and the

other officers of Dutchess to sign a continuing guarantee under

which each officer was jointly and severally liable for the debts

of Dutchess to Agway, in an amount not to exceed $300,000.

Petitioner signed the "Continuing Guarantee" on October 22, 1974.

Dutchess also obtained financing from First National City Bank of

New York, in the amount of $25,000, and from Citibank Eastern of

Albany, New York, in the amount of $200,000, based on personal

guarantees from John Peterson.

Dutchess drew down on the line of credit extended by Agway,

to the extent of $75,810 as of January 1975. In February 1975,

Dutchess made a repayment of $25,000 to Agway. In April 1975, by

which time Dutchess was indebted to Agway for approximately

$140,000, Dutchess provided Agway with a check for $15,000, and

2
(...continued)
shareholder/officer/employees" of Dutchess. The brief also
states that in September and October 1975, petitioner was a one-
third shareholder.
 - 4 -

the parties agreed to a repayment schedule. However, the check

was returned as a result of a lien filed on Dutchess' bank

accounts and accounts receivable by Citibank Eastern of Albany.

By June 1975, Dutchess was indebted to Agway in the amount of

$169,661.34. On June 25, 1975, attorneys for Agway requested

each officer of Dutchess to pay the amount due under the line of

credit, which totaled $175,244.97 with interest.

On June 18, 1975, Dutchess filed for Chapter 11 bankruptcy

protection in the U.S. Bankruptcy Court for the Southern District

of New York. In early July 1975, Agway filed a proof of claim in

that proceeding in the amount of $175,244.97. On July 7, 1975,

Agway filed a summons and complaint in the Supreme Court of New

York, Onondaga County, against the Dutchess officers, asking for

payment under the guarantee. On September 3, 1975, judgment was

entered against the officers of Dutchess in favor of Agway in the

amount of $205,522.72, which represented the original amount of

$169,661.34 due under the line of credit, plus interest and

costs.

On August 15, 1975, John Peterson, filed for Chapter 11

bankruptcy protection in the U.S. District Court for the Southern

District of New York. John Peterson died in 1986. Despite

efforts by petitioners and respondent, Woodrow Pereira's

whereabouts were and are unknown. Agway possessed and sold

petitioners' residence to satisfy its September 3, 1975, judgment
 - 5 -

against the officers of Dutchess, and on January 6, 1988,

judgment was entered which required petitioners to remove from

their residence located at 795 Rensens Lane, Muttontown, New

York. Petitioners vacated their premises pursuant to a

February 8, 1988, notice to vacate.

Petitioners claimed a business bad debt loss of $250,000 on

their 1988 Federal tax return as a result of the loss of their

residence in 1988. Petitioners carried over $232,361 of the

ordinary loss claimed but not used on their 1988 return to their

1989 return.

Discussion

The sole issue for decision is the proper treatment of the

loss resulting from the use of petitioners' residence to satisfy

the guarantee obligation of petitioner Glenn Peterson to Agway in

the amount of $205,522.72.3 Petitioners claim that they are

entitled to a business bad debt deduction under section 166(a).

Respondent asserts that the amounts paid on the guarantee

represent a contribution to the capital of Dutchess and should be

treated as a capital loss under section 165(g) and that, if the

3
While petitioners claimed a bad debt deduction of
$250,000.00 on their 1988 return, there is no evidence to support
any amount in excess of $205,522.72, the amount of the loss which
respondent has conceded petitioners are entitled to deduct as a
capital loss stemming from the worthlessness of Glenn Peterson's
shareholder interest in Dutchess. Respondent does not contest
the worthlessness of that interest.
 - 6 -

payment to Agway is held to represent a bad debt, it is a

nonbusiness bad debt deductible only as a short-term capital loss

pursuant to section 166(d). The burden of proof is on

petitioners. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 114

(1933). That burden is not lessened in a fully stipulated case.

Borchers v. Commissioner, 95 T.C. 82, 91 (1990), affd. 943 F.2d

22 (8th Cir. 1991).

Petitioners rely heavily on Putnam v. Commissioner, 352 U.S.

82 (1956), citing it for the proposition that payments by an

individual on a guarantee of corporate debt which are not then

repaid to the individual because the obligation to repay is

worthless give rise, as a matter of law, to bad debt deductions,

pointing to the following:

The familiar rule is that, instanter upon the
payment by the guarantor of the debt, the debtor's
obligation to the creditor becomes an obligation to the
guarantor, not a new debt, but, by subrogation, the
result of the shift of the original debt from the
creditor to the guarantor who steps into the creditor's
shoes. Thus, the loss sustained by the guarantor
unable to recover from the debtor is by its very nature
a loss from the worthlessness of a debt. This has been
consistently recognized in the administrative and the
judicial construction of the Internal Revenue laws
which, until the decisions of the Courts of Appeals in
conflict with the decision below, have always treated
guarantors' losses as bad debt losses. * * * [Id. at
85-86; fn. refs. omitted.]

This exact argument was raised and rejected in Casco Bank & Trust

Co. v. United States, 544 F.2d 528, 533-534 (1st Cir. 1976).

First, as the Court of Appeals for the First Circuit pointed out,
 - 7 -

the Supreme Court in Putnam was not called upon to decide whether

the payment on a guarantee of corporate debt created a bona fide

debt, but rather, where the guarantee in fact represented bona

fide debt, whether the payment on that guarantee by the

shareholder gave rise to a nonbusiness bad debt deductible only

as a short-term capital loss, or a business bad debt deductible

against ordinary income. Casco Bank & Trust Co. v. United

States, supra at 533-534.

Second, as the Court of Appeals for the First Circuit also

succinctly pointed out:

Since the Supreme Court handed down its decision
in Putnam, lower courts have considered whether a
guaranty of a corporation's obligations by its
stockholder is to be treated as a loan or a
contribution to capital. * * * [Id. at 534.]

The Court of Appeals went on to emphasize that the inquiry as to

how deductions for losses incurred as a result of such guarantees

should be characterized involves a question of fact, not law, and

that such inquiry is to be resolved in the context of traditional

debt-equity principles. Id.; see also In re Lane, 742 F.2d 1311,

1314-1315 (11th Cir. 1984); sec. 1.166-9(c), Income Tax Regs.4

4
The agreement in this case was made on Oct. 22, 1974.
While the regulation in general applies only to agreements
entered into after Dec. 31, 1975, and thus would not apply here,
the rule in paragraph (c) applies to payments, whenever made, on
agreements entered into before Jan. 1, 1976, and therefore does
apply in this case. Sec. 1.166-9(f), Income Tax Regs.
 - 8 -

Recognizing that no single factor is determinative, the

courts have applied a variety of factors in deciding whether a

guarantee was a loan or a capital contribution. Among these

factors are the name given to the certificate evidencing the

indebtedness, whether repayment depended on the success of the

business, whether the right to be repaid by the corporation for

payments on the guarantee was subordinated to other corporate

indebtedness, what the intent of the parties was in creating the

guarantee, whether the initial capital of the corporation was

adequate, whether outside sources would have extended the

corporation a line of credit without the guarantee, whether the

corporation repaid the guaranteed loans, and whether the

corporation gave the guarantor or the lender any security. In Re

Lane, supra; Plantation Patterns, Inc. v. Commissioner, 462 F.2d

712 (5th Cir. 1972), affg. T.C. Memo. 1970-182; Intergraph Corp.

& Subs. v. Commissioner, 106 T.C. 312 (1996). The ultimate

question is "'was there a genuine intention to create a debt,

with a reasonable expectation of repayment, and did that

intention comport with the economic reality of creating a

debtor-creditor relationship?'" Calumet Industries, Inc. v.

Commissioner, 95 T.C. 257, 286 (1990) (quoting Litton Bus. Sys.,

Inc. v. Commissioner, 62 T.C. 367, 377 (1973)).

We see no purpose to be served in analyzing each of the

foregoing factors as applied to the situation herein. It is
 - 9 -

obvious from our findings of fact that the record herein is

totally lacking in evidence sufficient to support petitioners'

contention that the guarantee and the payment thereon were

anything but capital in nature. The parties have stipulated that

Dutchess was undercapitalized, and the record is devoid of any

evidence as to the amount that any of the shareholders invested

in Dutchess in addition to the guarantee of the Dutchess'

indebtedness. Glenn Peterson guaranteed indebtedness used to

purchase apples sold by Dutchess to its principal customers.

Thus the indebtedness was an essential element in financing

Dutchess' operations.

We think the approach of the Court of Appeals for the Fifth

Circuit in dealing with a comparable situation in Plantation

Patterns, Inc. v. Commissioner, 462 F.2d at 722-723, is

particularly applicable herein:

The guarantee enabled Mr. Jemison to put a minimum
amount of cash into New Plantation immediately, and to
avoid any further cash investment in the corporation
unless and until it should fall on hard times. * * *
we think that the result is that Mr. Jemison's
guarantee simply amounted to a covert way of putting
his money "at the risk of the business". Stated
differently, the guarantee enabled Mr. Jemison to
create borrowing power for the corporation which
normally would have existed only through the presence
of more adequate capitalization of New Plantation.

Indeed this approach coincides with the analysis which this Court

applied in disposing of three cases involving facts very similar

to those involved here, namely, Titmas v. Commissioner, T.C.
 - 10 -

Memo. 1995-267, Slater v. Commissioner, T.C. Memo. 1989-35, and

Atkinson v. Commissioner, T.C. Memo. 1984-378. In those cases,

the taxpayers were shareholders of closely held corporations.

They had signed guarantees on behalf of their corporations, upon

which they had to make payment when their businesses failed. In

each case, we found that the payments were the equivalent of

contributions to capital.

In sum, the facts surrounding Glenn Peterson's guarantee of

Dutchess' debt do not show that he intended to create a bona fide

debtor-creditor relationship between himself and Dutchess, and do

not reflect a reasonable expectation of repayment on his part,

but rather show that the payment on the guarantee was a

contribution to capital. Calumet Industries, Inc. v.

Commissioner, supra at 286. Thus, we sustain the disallowance by

respondent of petitioners' bad debt deduction in the amount of

$250,000. Petitioners are entitled, as respondent concedes, to a

capital loss in the amount of $205,522.72, subject to the

limitations of section 1211.

Our conclusion moots the question whether, had we found that

the guarantee and its payment gave rise to a bona fide

indebtedness and did not constitute a contribution to capital,

the bad debt would have been a business rather than a nonbusiness

bad debt. We append the following comments on that issue only

because petitioners have devoted so much attention to it.
 - 11 -

At the outset, we note that in order to constitute a

business bad debt, the dominant motive for the indebtedness must

relate to the taxpayer's trade or business. United States v.

Generes, 405 U.S. 93 (1972). Here petitioners stumble on the

definition of "trade or business". They stress several times on

brief that the dominant motive of the guarantee was "to preserve

his [petitioner Glenn Peterson's] employment and generate future

corporate profits." But employment and corporate profits are two

distinct concepts. Petitioners misunderstand that Glenn Peterson

wore two hats with respect to Dutchess--one as a shareholder-

investor, and one as an employee-officer. He had, however, for

purposes of section 166, only one trade or business--that of

being an employee or officer. Investing in a single enterprise

is not a trade or business. Whipple v. Commissioner, 373 U.S.

193 (1963). In this connection, we note that petitioners do not

contend that Glenn Peterson was in the trade or business of

financing corporations. See Raymond v. United States, 511 F.2d

185, 189 (6th Cir. 1975). In order to qualify for ordinary loss

treatment, petitioners would have to show that Glenn Peterson

originally made the guarantee to protect his "business" of being

an employee. Eisenberg v. Commissioner, 78 T.C. 336, 349 (1982);

Shinefeld v. Commissioner, 65 T.C. 1092, 1099 (1976).

Petitioners have conceded on brief that Glenn Peterson and

the other shareholders drew "nominal salaries (if any)". We
 - 12 -

cannot believe that Glenn Peterson would have signed a guarantee

for $300,000 to protect a nominal salary. Garner v.

Commissioner, 987 F.2d 267, 272-273 (5th Cir. 1993), affg. T.C.

Memo. 1991-569. In this connection, we think it significant that

petitioners reported substantial amounts of "wages, salaries,

tips, etc." as ordinary income on their 1988 and 1989 returns.

This fact, coupled with the conceded nominal salary drawn from

Dutchess, points in the direction that Glenn Peterson's main

purpose was not to draw salary as an employee of Dutchess, but to

realize capital appreciation as a shareholder by way of the

hoped-for profitable operation of Dutchess. Indeed, petitioners

recognize the multiple nature of Glenn Peterson's role when they

repeatedly refer on brief to his status as an

"employee/officer/shareholder".

In any event, under the foregoing circumstances, the record

is insufficient to satisfy petitioners' burden of proof that

protection of Glenn Peterson's employment status was the dominant

motive for financing the guarantee. Eisenberg v. Commissioner,

supra at 349; Shinefeld v. Commissioner, supra at 1099. We

conclude that Glenn Peterson signed the guarantee in his capacity

as a shareholder, and therefore, if the payment represented debt

instead of a contribution to capital, petitioners would have been

entitled to a nonbusiness bad debt deduction, which would have

given rise to a short-term capital loss, subject to the
 - 13 -

limitations of section 1211. Sec. 166(d); United States v.

Generes, supra; Shinefeld v. Commissioner, supra.

Finally, we take note of the rhetorical question which

petitioners pose in their reply brief:

when Petitioners lost their residence to Agway as a
result of the guarantee, who was the real victim?
Agway or Petitioners?

We are not unsympathetic to the plight of petitioners, who lost

their home in the wake of the failure of Dutchess. Nevertheless,

petitioners may only take those deductions authorized by the

Internal Revenue Code. See Atkinson v. Commissioner, T.C. Memo.

1984-378.

Additions to Tax and Penalties

Petitioners failed on brief to raise the issue of the

additions to tax and the penalty. By not addressing these

issues, petitioners have effectively conceded them. Sundstrand

Corp. v. Commissioner, 96 T.C. 226, 344 (1991).

Decision will be entered

under Rule 155.