*48 Decision will be entered under Rule 50.
In 1944, petitioner deducted as a loss a $ 2,000 payment in compromise and settlement of his $ 5,000 note given as additional security in 1937 for the debt of a corporation of which he was managing director but which subsequently went out of business in 1938. Held, the amount paid by petitioner in settlement of the note was a nonbusiness bad debt within the meaning of section 23 (k) (4) of the Internal Revenue Code.
*60 These consolidated proceedings involve deficiencies in income tax for the calendar year 1944 of $ 1,177.85 for George Aftergood and *49 $ 1,177.84 for his wife, Kathryn Aftergood.
The issue to be decided is whether the compromise settlement of a $ 5,000 note for the sum of $ 2,000 resulted in (1) a taxable gain of $ 3,000 as respondent determined, (2) a loss of $ 2,000 as petitioner reported, or (3) a nonbusiness bad debt.
Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts are so found and are incorporated herein.
George Aftergood (hereinafter referred to as petitioner) and Kathryn Aftergood were husband and wife during the calendar year 1944. They resided together in Los Angeles, California, and filed separate returns on a cash basis for such year with the collector of internal revenue for the sixth district of California.
In 1931, petitioner organized the Hollyvogue Knitting Mills, a corporation (hereinafter referred to as Hollyvogue). His brother-in-law and wife were the principal stockholders. Petitioner was the managing director of the firm, devoted full time to its operations, but owned no stock. Due to a shortage of working capital, the firm *61 adopted the practice of financing its accounts receivable. Such practice involved an assignment of the accounts to a factor who in turn*50 advanced money to Hollyvogue.
In 1935, petitioner made arrangements with one H. I. Silverman (hereinafter referred to as Silverman) to finance the firm's accounts receivable. By early 1937, the corporation had become indebted to Silverman in amounts totaling $ 5,000. This debt arose in two ways. Silverman, from time to time, made outright loans to the corporation for the purpose of meeting its payroll and for other expenses. Occasionally payments on accounts receivable assigned to Silverman, and on which he had already advanced money to the corporation, were made directly to Hollyvogue. It did not always reimburse Silverman from such payments for the full amount which he had advanced on the account. The difference would be entered on the corporation's books as a debt owed to him.
On February 13, 1937, petitioner executed a personal demand note to Silverman for $ 5,000, with interest at 6 per cent, secured by collateral of 50 shares of Hollyvogue stock owned by his wife. The stock was arbitrarily valued at $ 7,500. The note was executed by petitioner at the express request of Silverman as additional security for the corporation's indebtedness to him. Petitioner received no*51 consideration as maker. It was intended that the corporation should pay the obligation, and it paid interest on the note aggregating several hundred dollars.
On February 15, 1937, the following entry was made in the general journal of the firm: "H. I. Silverman, $ 5,000," "Donated Surplus," "Assumed by K. Aftergood." No financial statements of the corporation after that date showed any indebtedness to Silverman. The effect of this entry was to show as paid on the books of the company its $ 5,000 indebtedness to Silverman, and to show an addition to surplus of $ 5,000. The purpose of such entry was an attempt to improve temporarily the dwindling credit standing of the firm. The remaining year of its life was devoted to a desperate but unsuccessful effort to stave off financial collapse. On March 30, 1938, the directors agreed that the corporation could not continue in business, and authorized its officers to make an immediate general assignment of all its assets for the benefit of creditors. The evidence does not show whether Silverman presented a creditor's claim. The corporation carried on no further business activity after 1938.
Later in 1938, petitioner organized a new corporation*52 named California Knitting Mills. In this venture, Silverman loaned Kathryn Aftergood $ 1,500 and accepted her shares of stock in the new corporation as collateral. Silverman was named a director of the corporation. Petitioner was manager, but owned no stock. A department or division of California Knitting Mills did business under the name of *62 Hollyvogue Sportswear Company. In 1944 petitioner reported a net profit of $ 4,261.90 from this division's operation.
Silverman died in 1943. Bessie Silverman, his widow and sole beneficiary, filed suit against petitioner on January 31, 1944, to collect principal and accrued interest (less $ 677.50 interest paid) on the unpaid $ 5,000 note. She alleged the nonexistence of Hollyvogue and the complete worthlessness of its stock, given as collateral. On May 10, 1944, Bessie Silverman accepted a settlement of $ 2,000 and released petitioner from all further obligations under the note.
In his 1944 return, petitioner reported the payment of the $ 2,000 note settlement as a business loss. Respondent disallowed this deduction; and, in addition, determined that the remaining $ 3,000 liability from which petitioner was absolved constituted*53 taxable income.
OPINION.
Respondent contends that petitioner's payment of $ 2,000 in compromise and settlement of the action on his promissory note of $ 5,000 was in discharge of an individual obligation and, therefore, is not deductible from gross income; and, further, that the release and cancellation of the $ 3,000 was income properly includible in his 1944 Federal income tax return. Petitioner claims that the $ 2,000 payment was a business expense or a business loss properly deductible in 1944. In the alternative he contends that, in the event that income in the amount of $ 3,000 was realized, $ 5,000 is deductible (a) as a business expense or loss; (b) as an uncollectible account due from the bankrupt corporation; or (c) as a long-term capital loss through increase of the basis of investment in the defunct corporation.
The record in this case discloses that by February 13, 1937, Hollyvogue Knitting Mills owed Silverman $ 5,000. Because Silverman wanted additional security on this debt, petitioner executed a $ 5,000 promissory note on that date. The evidence is clear that the debt was that of Hollyvogue and not a personal obligation of petitioner prior to such date. He received*54 nothing of value when he executed the note and eventually sustained a sizeable out-of-pocket loss when required to settle it. He did no more than lend his name to the corporation as added security for an aggregation of debt which it owed to Silverman. He was an accommodation maker or guarantor of the corporation's debt. 1
The entry in the corporation's general journal on February 15, 1937, purporting to wipe out its indebtedness to Silverman and to show a *63 $ 5,000 donation to surplus by petitioner's wife, does not change the fundamental nature*55 of petitioner's position.
As a guarantor, petitioner's liability was contingent; and even though Hollyvogue became irredeemably insolvent the following year and he knew without question that he, personally, must pay its debt at Silverman's demand, he was not entitled to a deduction until payment was, in fact, made. Eckert v. Burnet, 283 U.S. 140">283 U.S. 140 (1931).
In 1944, petitioner's contingent liability was realized by the payment of $ 2,000 in settlement of Bessie Silverman's suit on his note.
Any resulting deduction must be on account of a nonbusiness bad debt under section 23 (k) (4) of the Code. 2 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*56 (C. A. 9, 1945). The cases of Abraham Greenspon, 8 T. C. 431 (1947), and Frank B. Ingersoll, 7 T. C. 34 (1946), relied on by petitioner are distinguishable on their facts.
Having determined that petitioner, as guarantor of the corporation's obligation, sustained a nonbusiness bad debt under *57 section 23 (k) (4), it follows that he incurred no taxable gain from the note settlement transaction.
Decision will be entered under Rule 50.
Black, J., dissenting: I think the facts clearly show that in the taxable year petitioner incurred a loss of $ 2,000 and that he is entitled to deduct that loss under section 23 (e) (1) or (2) of the Code. I am unable to agree with the majority opinion in this case that petitioner's loss was of a nonbusiness bad debt within the meaning of section 23 (k) (4) of the Code. When petitioner paid the $ 2,000 in 1944 in compromise of his indebtedness of $ 5,000 to Silverman, he had no debt against anyone. No debtor was in existence.
*64 The petitioner testified, and other evidence indicates, that the corporation liquidated and went out of business in 1938. The majority opinion found merely that the corporation carried on no further business activity after 1938. I think that the record justifies a finding that the corporation not only went out of business in 1938, but that it also ceased to exist at that time. If that be true, it follows that when the petitioner settled the suit by the payment of $ 2,000 in 1944, no debt from*58 the corporation to the petitioner could then arise. Abraham Greenspon, 8 T.C. 431">8 T. C. 431. See also Fox v. Commissioner, 190 F.2d 101">190 F. 2d 101.
In the case of Frank B. Ingersoll, 7 T. C. 34, we held that a stockholder of a corporation who guaranteed a mortgage note of the corporation and subsequently had to pay about $ 12,000 under his guarantee, after the reorganization of the corporation in a bankruptcy proceeding, sustained a business loss. So it seems to me that under the foregoing decisions petitioner is entitled to an ordinary loss of $ 2,000 and that his loss should not be limited by the provisions of the Code applicable to nonbusiness bad debts.
Footnotes
1. The Civil Code of California, Div. 3, pt. 4, tit. 15, ch. 1, art. 2, sec. 3110 provides:
* * * An accommodation party is one who has signed the instrument as maker, drawer, acceptor, or indorser, without receiving value therefor, and for the purpose of lending his name to some other person. Such person is liable on the instrument to a holder for value, notwithstanding such holder at the time of taking the instrument knew him to be only an accommodation party.↩
2. 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.↩