*986 LOSSES - PAYMENTS MADE IN COMPROMISE OF LIABILITIES UNDER CONTRACTS OF GUARANTY AND ENDORSEMENT. - Petitioner was sole stockholder of a corporation which in 1924 became insolvent and went into the hands of a creditiors' committee, with a large aggregate indebtedness of which petitioner was either guarantor or endorser to the extent of $655,695.14. Petitioner transferred all his stock to the creditiors' committee to be held by it under a voting trust agreement, and the creditors took charge of the corporation, retaining petitioner as manager. The debts of the corporation were compromised and settled by the corporation and the liabilities of petitioner as endorser and guarantor were compromised by payments aggregating $98,500, made by him in 1925, 1926, and 1927 out of his own personal funds, resulting in the rehabilitation of the corporation and the restoration of value to petitioner's stock, which was returned to him free and unencumbered in 1927. Soon thereafter a reorganization took place which was apparently profitable to petitioner. Held, petitioner has not shown deductible losses growing out of the transactions. John P. Dillon,9 B.T.A. 177">9 B.T.A. 177, distinguished. *987
*169 This proceeding involves deficiencies in income tax for 1926 in the sum of $2,416.12 and for 1927 in the sum of $8,658.55. Petitioner *170 alleges that the respondent erred in not allowing as deductions from gross income the sums of $16,469.34 for the year 1926 and $68,645.09 for the year 1927 as losses suffered by petitioner because of payments made by him to secure release from his liability as accommodation endorser or guarantor of obligations of the Menihan Co., a corporation, and for which he did not receive reimbursenent. Respondent contends that the alleged losses were in the nature of capital expenditures made for the purpose of protecting petitioner's investment in the stock of the corporation, and not deductible losses or bad debts.
FINDINGS OF FACT.
The petitioner resides in Rochester, New York, and has been engaged in the shoe-manufacturing business for over 30 years. In 1905 he incorporated his business as the Menihan Co. under the laws of New York, to engage in the manufacture of women's shoes. *988 He was the president and principal stockholder, owning 497 shares of the total of 500 shares, and the remaining three shares were issued to his nominees for qualification purposes. The company prospered to such an extent that in 1922, 1923 and 1924 it opened and operated additional factories in Rochester and Buffalo, New York. Because of strikes, overexpansion and adverse trade conditions the company became insolvent, and after an examination by accountants was so notified by its bankers early in 1924.
As of March 31, 1924, a statement of the company's assets and liabilities is as follows:
| Assets | Liabilities | ||
| Cash | $609.16 | Bank overdraft | $9,411.56 |
| Accounts receivable, net | 268,190.14 | Notes payable | 624,500.00 |
| Inventory | 297,754.95 | Accounts payable | 260,680.60 |
| Value of life insurance | 5,521.00 | Notes payable to contractor (Buffalo plant) | 40,000.00 |
| Land, buildings, machinery and equipment at sound values reported by American Appraisal Co. at 10/1/23 | 676,032.08 | Mortgage payable on plant and equipment | 160,000.00 |
| Dies, patterns and lasts - appraised at 10/31/23 at $168,419.84 | 1.00 | Capital stock and deficit | 153,516.17 |
| Total | 1,248,108.33 | Total | 1,248,108.33 |
*989 Notes and accounts were due and uunpaid to banks and merchandise creditors. It had been the custom of the petitioner for many years to endorse the corporation's commercial paper and notes and guarantee certain merchandise accounts upon the express requirement of the banks and certain merchandise creditors. As of March 31, 1924, the petitioner was liable as guarantor or endorser on notes and guaranty contracts in the amount of $655,695.14, and was insolvent.
*171 Petitioner was notified by the banks and other creditors that the business could not go on in its then condition and that some adjustment or settlement must be made. After consultation with bank and certain merchandise creditors and their attorneys, it was the opinion of all those concerned that it would be to the best interests of all creditors, the petitioner and the corporation to endeavor to save the corporation and petitioner from bankruptcy and other court proceedings and continue the business, if possible.
With this end in view a committee of five, representing the largest merchandise and bank creditors, was constituted for the purpose of taking charge of the affairs of the corporation. On April 16, 1924, the*990 petitioner made an assignment of the 497 shares of stock standing in his name and the remaining three shares, which he controlled, to the committee in order that it might have complete control of the corporation and its business under a voting trust agreement. The committee under date of April 17, 1924, addressed a letter to all of the creditors informing them of the condition of the corporation's affairs, giving an account of its actions and proceedings, and offering a settlement in one of two options, to wit, either a cash settlement of 35 percent in full, or 50 percent on a time basis. A voting trust agreement was executed between petitioner and the committee members as trustees, by which the latter were empowered to vote the stock and were authorized to deliver trustees' certificates to petitioner for his stock and redeliver the stock to him or his assignee upon termination of the trust. Committee representatives were placed on the corporation's board of directors and in key positions in the management and the business was continued pending determination of its ultimate disposition. The petitioner was employed as general manager of the business at a salary of $15,000 per year*991 and in addition 25 percent of the net profits in excess of $60,000.
In August 1924 George H. Harris, an attorney and member of the creditors' committee, went to Boston to report to his clients and other creditors on the condition of the corporation's and petitioner's affairs and the prospect of settlement. A number of creditors in the vicinity of Boston were consulted and it was determined that if the company would pay 50 cents on the dollar within 10 years, and petitioner would pay 15 percent as a condition to being released from any guaranties and endorsements upon which he was liable and would agree not to make any claim against the corporation for the amounts so paid by him, such a settlement would be satisfactory. After Harris' return to Rochester the proposed settlement was considered by other members of the committee and, after an agreement with petitioner that he would make no claim for reimbursement from the corporation for moneys paid out by him on *172 endorsements and guaranties of the corporation's obligation, the plan was submitted to the creditors by letter of September 12, 1924.
The petitioner was required to state in writing to each of his creditors*992 who held his personal endorsement or guaranty that their acceptance of the company's settlement would in no manner affect or impair his personal liability to them. This was first done by a letter to each of these creditors who held petitioner's guaranty or endorsement, and then by a unilateral agreement.
In this letter of September 12, 1924, the committee gave a brief resume of its actions, stating that claims to the amount of $130,000 had been eliminated by acceptance of the 35 percent cash settlement proposed in the letter of April 17, and it was stated therein that the unsecured bank creditors of the Menihan Co., having claims of approximately $600,000, had agreed to accept in full satisfaction of their claims against the corporation 50 percent payable in bonds of the corporation secured by a mortgage on its real estate payable in 10 years, provided all other creditors of the corporation would agree to accept 50 percent in full settlement of their claims payable in the promissory notes of the Menihan Co. dated October 1, 1924, and falling due and payable in semiannual installments of 5 percent, beginning April 1, 1925. Under this proposal the banks would not receive their 50*993 percent until 1934, while all other creditors would receive their 50 percent in full by 1929. The statement of assets and liabilities of the corporation accompanying this letter did not list as a liability any amount owing petitioner on account of payments to be made by him on account of his endorsements and guaranties of the corporation's paper and accounts. The affairs of the Menihan Co. were finally adjusted on the basis proposed in the letter.
In order to effectuate his agreement to pay 15 percent of his liability in full settlement of his endorsements and guaranties, the petitioner executed and delivered to the Union Trust Co. of Rochester, New York, a deed of trust dated October 1, 1924, but not acknowledged until June 30, 1925, by which he transferred his home, 10 promissory notes of $2,732.71 each, which had been given him by the Menihan Co. on account of claims which he had settled out of his own individual funds, the voting trust certificate for 497 shares of stock in the Menihan Co. and a one-half interest in the bonus of his employment contract with the company. This was to secure the payment of his several notes aggregating $98,050 which he tendered in settlement*994 of the 15 percent which he proposed to pay in full settlement of his liability as guarantor and endorser. These notes were dated October 1, 1924, and provided for payment in 10 equal semiannual installments with interest at 6 percent. It was provided in the trust deed that the notes should be delivered to the payees in composition and satisfaction of their claims against the petitioner.
*173 It was also provided in the deed of trust that if petitioner should well and truly pay off the notes, the trusteed property should be returned to him free of lien.
Under this arrangement petitioner paid to these creditors on whose paper he was endorser and guarantor, during the year 1925, the sum of $12,877.36; during the year 1926, the sum of $16,469.34; and during the year 1927, the sum of $68,645.09. Each of these amounts paid as stated above was claimed as a deductible loss by petitioner in his returns for the respective years. That for 1925 was allowed by the respondent, but those for 1926 and 1927 were disallowed on the ground that they were capital expenditures. The Commissioner, in disallowing these claimed losses for 1926 and 1927, stated in his deficiency notice that, *995 "The amount paid in connection with the obligations of the Menihan Co. is held to represent a capital expense and is not an allowable deduction from gross income as a bad debt under article 151, Regulations 69." The payments above enumerated fully discharged petitioner's abligations to his personal creditors under the deed of trust; the lien was released and the collateral returned to him. Petitioner was never reimbursed in any way by the corporation or otherwise for these payments made by him, nor did he make any claim therefor.
The original voting trust agreement terminated within two years and, in order that the stock in the Menihan Co. should continue to be held by the trustees, another voting trust agreement was entered into April 1, 1925, between petitioner and the trustees, by which the parties had similar powers for a period of five years.
Petitioner at all times had the purpose and desire of obtaining the return of his stock in the Menihan Co. and regaining control of it and its operations. In order to accomplish this it was necessary that the Menihan creditors should be paid the remaining notes as agreed upon. For this purpose petitioner, in March 1927, borrowed*996 $78,769.96 and paid it in to the company in order to pay off the notes due the creditors. Of this sum, $68,769.96 was used to pay off creditors and petitioner was given credit for the additional $10,000.
The $68,769.96 paid in to the corporation in March 1927 by petitioner was considered by him as a capital contribution and no claim for deduction therefor is or has been made, and no question is now raised relative to it. Petitioner's stock which had been in the hands of a creditor's committee under a voting trust was returned to him on April 28, 1927. Thereafter in 1927 the corporation was reorganized and petitioner received 5,000 shares of preferred stock of a par value of $100 per share and 19,000 shares of no par common stock. Petitioner filed his income tax returns on a cash receipts and disbursements basis.
*174 OPINION.
BLACK: The only question for decision is whether the amounts of $16,469.34 and $68,645.09 paid by petitioner in 1926 and 1927, respectively, on account of his liabilities as endorser or guarantor were deductible losses for those years, or capital expenditures or investments.
Pertinent provisions of the Revenue Act of 1926 are:
SEC. 214. *997 (a) In computing net income there shall be allowed as deductions:
* * *
(4) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in trade or business;
(5) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in any transaction entered into for profit, though not connected with the trade or business; * * *
* * *
(7) Debts ascertained to be worthless and charged off within the taxable year * * *.
Briefly stated, it is contended by the petitioner the payments made by him were in liquidation of an individual liability, that he could not legally claim payment from the Menihan Co., and that they were not capital expenditures. Respondent claims that the payments were not losses or bad debts, but were capital expenditures.
Manifestly if the only issue we had to decide was whether or not the $16,469.34 and $68,645.09 in question were debts ascertained to be worthless and charged off within the respective taxable years, we would have to decide that they were not. Respondent in his deficiency notice stated that he was disallowing the items because they were not bad debts. We*998 agree with respondent that these amounts did not represent bad debts at all.
The petitioner was endorser or guarantor on a large amount of the indebtedness of the Menihan Co. If the Menihan Co. had paid as far as it could pay on this indebtedness and thereafter the petitioner had paid the balance under his guaranty, he would have been subrogated to the rights of the creditors and whatever amounts he might have paid under such circumstances would have immediately become a debt due to him by the Menihan Co., and if thereafter it had been demonstrated that the debt was worthless petitioner could have charged it off and secured a proper deduction from his gross income as provided by statute. But petitioner did not have the right of subrogation against the Menihan Co. because he did not pay the entire remainder of the debt, which is requisite before subrogation is allowable. Moreover he expressly waived his right of subrogation. . So whatever deductions, if any, petitioner is entitled to take on account of the payments made must be taken as losses, and not as debts against the Menihan Co. ascertained to be worthless and charged off.
*999 *175 Petitioner recognizes this situation and in his petition makes no claim that the amounts in question represent debts ascertained to be worthless and charged off. He does claim, however, that the amounts represent losses incurred in his trade or business or in transactions entered into for profit and are therefore allowable deductions under the statute.
Did petitioner really sustain any losses from the transactions narrated in our findings of fact? We think none have been satisfactorily proved. Losses to be deductible must be from closed and completed transactions. Undoubtedly petitioner made payments of $16,469.34 in 1926 and $68,645.09 in 1927 in compromise settlement of his guaranty or endorsement of the Menihan Co.'s indebtedness, but we cannot say that these payments resulted in any loss to petitioner. If taken alone and without reference to other facts proved in the proceeding, perhaps we might say that they did result in losses. But all the facts proved, taken together, show that by means of the settlement which the Menihan Co. effected with its creditors and the settlement which petitioner made in respect to his guaranty liability, all of which transactions*1000 were intimately connected with each other, the Menihan Co. was financially rehabilitated and petitioner's stock therein was made valuable.
In 1927, the year in which petitioner claims a $68,645.09 loss by reason of a payment made under his guaranty liability, his stock in the Menihan Co. was returned to him and in that same year the Menihan Co. was reorganized and petitioner received 5,000 shares of preferred stock of a par value of $100 per share and 19,000 shares of common stock of no par value in the reorganized corporation. No evidence was offered as to the fair market value of the preferred stock in the reorganized company, but evidence was given that some of the common stock of the company which was taken by others at the time of the reorganization was sold to them for $10 per share.
What profit, if any, petitioner realized from the reorganization of the Menihan Co. which took place in 1927, after all the indebtedness of the Menihan Co. had either been fully paid or satisfactorily settled and petitioner had been released from his liability as endorser and guarantor and his stock had been returned to him, we do not know. The complete facts with reference to this reorganization*1001 are not before us. However from such facts as are before us with reference to all these transactions, we cannot say that petitioner has sustained any loss. Whatever losses were sustained seem to have been sustained by the creditors and not by petitioner.
As we view it, the payments which petitioner made in compromise of his guaranty and endorsement liabilities, under the particular circumstances in this case, were capital payments which yielded him good results, and we know of no provision of law which would entitle him to claim them as deductible losses.
*176 Petitioner urges in support of his contentions our decision in . We think however that the facts in that case are distinguishable from those in the instant case. In the Dillon case the taxpayer, together with other former stockholders of the Farmers National Bank, a closed bank, had guaranted $100,000 of the old paper of the closed bank, which had been taken over by a new bank, the Sterling National Bank. In 1921 these guarantors were called upon to make good their guaranty and Dillon paid $28,000 in settlement of his obligation thereunder. The facts further showed*1002 that Dillon was never reimbursed in any way for this payment and that moreover the payment did not rehabilitate the bank and make Dillon's stock in the bank more valuable. On the contrary, the new bank closed its doors the following year.
We do not think therefore that our allowance of the loss in the Dillon case, under the circumstances which existed therein, can be taken as a precedent which would authorize the allowance of the losses which petitioner claims in the instant case.
Reviewed by the Board.
Decision will be entered for respondent.
TRAMMELL, ARUNDELL, SEAWELL, and ADAMS dissent.