*111 X made a $20,000 advance to W corporation for which he received a promissory note. Y, co-equal shareholder with X in W corporation, made an identical advance. W corporation never paid any dividends to X or Y. Held, the $20,000 advance by X represented a contribution to capital.
X and Y agreed to indemnify a surety company on a performance and labor bond for W corporation. X and Y also cosigned a loan from C bank to W corporation. After W corporation became insolvent, X expended funds pursuant to the bond and the loan agreements. Held, expenditures made by X are deductible as nonbusiness bad debts.
MEMORANDUM FINDINGS OF FACT AND OPINION
WILES, Judge: Respondent determined a deficiency in petitioners' income tax for the taxable year 1969 in the amount of $1,732.14.The issues are: (1) Whether a $20,000 advance made by petitioner represented a bona fide loan or a contribution to capital; and (2) whether amounts paid under an indemnity agreement and a loan agreement are deductible under
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
H. Leslie Bowen (hereinafter referred to as petitioner) and Esther L. Bowen are husband and wife who were legal residents of Lincoln, Nebraska at the time the petition was filed. They filed their Federal income tax return for the year 1969 with the district director of internal revenue in Kansas*113 City, Missouri.
Westcott-Bowen Construction Co. (hereinafter referred to as Westcott-Bowen or the Company) was incorporated under the laws of the State of Nebraska on September 9, 1949, and was engaged as a general contractor in the construction business.
Lee W. Westcott (hereinafter referred to as Westcott) was president of the Company and petitioner was vice president. Both Westcott and petitioner were corporate directors. Petitioner was a full-time employee of the Company and held no other salaried position during 1961 and 1962. Petitioner's salaries for 1961, 1962 and 1963 were $10,600, $10,400 and $7,200, respectively. In 1963 Westcott-Bowen became insolvent as a result of which the assets were then liquidated. On March 26, 1969, Westcott-Bowen was dissolved for nonpayment of occupation taxes.
The original capitalization of Westcott-Bowen was $5,000 of which $2,500 was contributed by petitioner and $2,500 by Westcott. As of 1960 Westcott and petitioner were co-equal shareholders in the Company, the capital stock acquired (including original capitalization) by each being as follows:
| Year | Amount |
| 1949 | $ 2,500.00 |
| 1950 | 10,000.00 |
| 1951 | 2,500.00 |
| 1952 | 5,000.00 |
| 1953 | 1,600.00 |
| 1954 | 3,400.00 |
| 1955 | 5,000.00 |
| 1960 | 4,000.00$0 |
| Total | $34,000.00 |
*114 The contributions to capital made from 1949 through 1955, inclusive, and in 1960 were for the purpose of providing Westcott-Bowen with additional working capital.
On August 2, 1961, petitioner and Westcott made advances of $20,000 each to Westcott-Bowen. Petitioner received a $20,000 promissory note that was made payable, after thirty-six (36) months, to himself or his wife. The note stated that interest was payable at the rate of six percent per annum from the date the note was signed. The note was signed on behalf of the Company by petitioner and Westcott in their capacities as officers. Westcott's advance to the Company was identical to the one made by petitioner. Westcott-Bowen paid petitioner $2,500 in 1963 and $6,599.97 in 1969 on the advance made in 1961.
On August 11,1961, Westcott-Bowen obtained a performance bond and a labor and material payment bond from the Trinity Universal Insurance Company (hereinafter referred to as Trinity) in the amount of $1,154,826 for the construction of a building for Dorsey Laboratories in Lincoln, Nebraska.Westcott-Bowen was obligated to indemnify Trinity for any moneys which it expended pursuant to the terms of these bonds. Petitioner*115 and Westcott were also listed on the contracts individually as indemnitors. The contract provided that the indemnitors, as well as Westcott-Bowen, were liable to indemnify Trinity. As a result of the insolvency of Westcott-Bowen, Trinity fulfilled its obligations under the performance and payment bonds by paying $135,716.36 to subcontractors and materialmen to complete the construction of the Dorsey Laboratories. In 1969 petitioner paid Trinity $17,468.99 to indemnify it for funds expended under the performance and payment bonds.
On September 28, 1962, the National Bank of Commerce Trust & Savings Association (hereinafter referred to as the Bank of Commerce) of Lincoln, Nebraska, approved a loan in the amount of $105,000 to Westcott-Bowen. The loan was evidenced by a promissory note which was signed by petitioner and Westcott in their capacities as corporate officers; and it was also signed by petitioner, Westcott and their respective wives individually. In 1964, after the Company became insolvent, petitioner paid $6,384.60 to the Bank of Commerce under the promissory note signed in 1962. The Bank of Commerce then assigned its rights against the estate of Westcott, at that*116 time deceased. In 1969, petitioner received $869.02 from Westcott-Bowen.
No formal dividends were ever paid to either petitioner or Westcott.
On the 1969 Federal joint income tax return petitioner claimed a miscellaneous deduction in the amount of $14,111.57, that amount allegedly consisting of the $20,000 advance less the payments received of $2,500 and $6,599.97. Petitioner contended that this balance "was determined to be completely worthless and is treated as a bad debt." Petitioner also deducted as long-term capital losses $16,599.97 and $6,384.60 for his payments to Trinity on the bonds and the Bank of Commerce loan, respectively.
In a notice of deficiency dated September 26, 1972, respondent disallowed petitioner's deduction of $14,111.57 on the basis that the $20,000 advance made in 1961 represented a contribution to capital rather than a loan. Respondent also stated that, if the advance was determined to be a loan, it was a nonbusiness bad debt subject to deduction only as a capital loss.
OPINION
The first issue is whether the $20,000 advance made by the petitioner on August 2, 1961, should be classified as a loan or a contribution to capital.
A determination of whether an advance made by a stockholder to a close corporation creates a true debtor-creditor relationship or actually represents a contribution of capital depends upon the particular facts of each case.
After full consideration of all of the facts in this case, we hold that the $20,000 advance made by petitioner was in reality a contribution to capital. The only factor in favor of finding that the advance was a bona fide loan was the form in which it was made. Thus, the signing of a promissory note which provided for a fixed maturity date and for the payment of interest establishes some evidence that the parties intended the transaction to be a loan. The objective expression of intent as contained in such formal documentation, *119 however, cannot alone be controlling of the characterization given the transaction.
Although the promissory note called for the payment of interest at the rate of six percent per annum, petitioner has presented no proof that any interest was ever paid on the $20,000 advance. The failure to pay interest on the advance as required by a note is a factor in determining whether the parties intended a true debtor-creditor relationship. See
Petitioner's $20,000 advance was made in direct proportion to his interest as a shareholder in the Company. This raises a strong inference that the advance represented investment capital.
Westcott-Bowen never paid any formal dividends to either petitioner or Westcott, which is another factor militating against finding a true debtor-creditor relationship.
The cumulative effect of the factors noted above is that, although the parties went through the formalities of documenting that the advance was a loan, petitioner did not support this action by evidence of the substantive economic reality of the transaction. We therefore hold that the $20,000 advance by petitioner constituted a contribution to capital rather than a loan.
Since we hold that petitioner's advance was a contribution to capital, we do not reach respondent's alternative argument that any loss realized is deductible only as a nonbusiness bad debt.
The second issue is whether the amounts*122 paid by petitioner pursuant to the bond and loan agreements are business bad debts or nonbusiness bad debts.
*123 Petitioner contends that the payments made pursuant to the bond and loan agreements are deductible as losses on worthless debts incurred in connection with his trade or business. Respondent contends that neither the indemnification agreement nor the loan agreement were incurred in connection with petitioner's trade or business and that any losses arising from these items are not deductible as ordinary losses under
The construction business of Westcott-Bowen is not the trade or business of petitioner, its 50% shareholder and vice president.
In the Generes case the court held that the taxpayer was not entitled to a business bad debt deduction under
In this case the petitioner's salary was approximately $10,000 per year and his capital in the firm was $54,000. It seems unreasonable to believe that petitioner would have entered into an indemnification arrangement for over $1,000,000 and cosigned a loan for $105,000 merely to protect his annual salary. Furthermore, the only evidence offered by the petitioner was his own self-serving testimony.
Under the authority of the Generes case we find that the transactions were entered into by petitioner primarily to protect his investment. We conclude and find that the petitioner's dominant motivation in entering into the indemnification agreement and cosigning*125 the loan was to protect his investments in Westcott-Bowen and that the protection of his income of salaries was only an incidental motivation. Accordingly, we hold that the losses suffered by petitioner in connection with the indemnification agreement and the loan resulted from nonbusiness bad debts are therefore deductible only as short-term capital losses under
Decision will be entered for the respondent.
Footnotes
1. All statutory references are to the Internal Revenue Code of 1954, as in effect during the year in issue, unless otherwise indicated. ↩
2.
SEC. 166 . BAD DEBTS.(a) General Rule. -
(1) Wholly worthless debts. - There shall be allowed as a deduction any debt which becomes worthless within the taxable year. ↩
3.
SEC. 166 . BAD DEBTS.(a) General Rule. -
(1) Wholly worthless debts. - There shall be allowed as a deduction any debt which becomes worthless within the taxable year.
* * *
(d) Nonbusiness Debts. -
(1) General rule. - In the case of a taxpayer other than a corporation -
(A) subsections (a) and (c) shall not apply to any nonbusiness debt; and
(B) where any nonbusiness 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.
(2) Nonbusiness debt defined. - For purposes of paragraph (1), the term "nonbusiness debt" means 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. ↩