Cox v. Commissioner

United States Court of Appeals,

Fifth Circuit.

No. 94-41087.

Richard W. COX and Kay L. Cox, Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nov. 6, 1995.

Appeal from the United States Tax Court.

Before WISDOM, DUHÉ and BARKSDALE, Circuit Judges.

WISDOM, Circuit Judge:

Mr. and Mrs. Richard Cox, plaintiff/appellants, appeal a

decision of the United States Tax Court upholding the findings of

the Commissioner of Internal Revenue (Commissioner) regarding the

plaintiffs' 1987 tax return. The plaintiffs challenge the

Commissioner's decision to disallow their bad debt deduction for a

loan to their wholly-owned corporation. Additionally, the

plaintiffs assert that a nonjudicial foreclosure on their personal

property, which they pledged as security for a loan to their

corporation, also qualifies as a bad debt deduction or,

alternatively, did not result in a taxable gain. We find that the

tax court's decision is supported by the facts of this case and,

accordingly, we AFFIRM.

I.

Richard Cox began working for Texas Light Bulb Supply Company

(Light Bulb), which is located in Austin, Texas, in 1972. His

salary from this position was the family's primary income for many

1
years. By 1987, the Coxes were the sole shareholders of Light

Bulb.

Between 1972 and 1987, Richard lent Light Bulb a total of

$100,000, which the corporation was scheduled to repay. At the end

of 1987, the outstanding amount on these unsecured loans totalled

$59,198 (the Cox loan).

In two transactions completed in May 1987, Light Bulb renewed

two promissory notes from MBank, amounting to approximately

$1,125,000. Those notes (the MBank loans) matured in August of the

same year. Richard signed the notes both as president of Light

Bulb and as co-maker. Each note had a choice-of-law provision

designating Texas law as controlling.

In June 1987, the Coxes borrowed $342,000 from Frontier

National Bank (Frontier). The Coxes signed as the makers of this

note (the Frontier loan). To secure payment of the Frontier and

MBank loans, the Coxes executed a deed of trust, which provided

that MBank's security interest was inferior to Frontier's interest.

The deed of trust covered property that was owned by the Coxes and

leased by them to Light Bulb. The property served as Light Bulb's

place of business.

After Light Bulb defaulted on the MBank loans, MBank had a

receiver appointed for Light Bulb in September 1987, asserting that

approximately $1,100,000 was still outstanding on the loans. On

October 13, 1987, MBank began nonjudicial foreclosure on the

property named in the deed of trust. Two days later, Light Bulb

filed for bankruptcy under Chapter 11. In its bankruptcy filing,

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Light Bulb listed its $1,100,000 debt to MBank and the debts to its

unsecured creditors, but omitted listing any debts to the Coxes.

At the time of the bankruptcy filing, Light Bulb still owed

the Coxes $59,198. Relying on the advice of Eric Borsheim, the

attorney hired to manage Light Bulb's bankruptcy, the Coxes decided

not to include that debt on Light Bulb's bankruptcy filing.

Borsheim advised the Coxes that listing their claim against Light

Bulb could jeopardize the approval of any reorganization plan in

which they retained the company because Light Bulb lacked

sufficient capital and assets to compensate fully its unsecured

creditors.

In December 1987, MBank purchased the Coxes's property for

$490,000 at the foreclosure sale, at which time the Coxes's

adjusted basis in the property was $451,831. Subsequently, MBank

paid Frontier $342,888.47, which was equivalent to the outstanding

amount on the Frontier loan. MBank marked "Payoff of first lien"

on the check with which it paid Frontier. An internal MBank

memorandum states that MBank paid off the Frontier loan, and did

not purchase it. Other MBank records, however, indicate that MBank

raised the outstanding indebtedness of Light Bulb and the Coxes by

an amount equal to the Frontier loan balance, suggesting that MBank

purchased the loan. During the reorganization negotiations, MBank

also refused to discuss its handling of the foreclosure proceeds.

At trial, several witnesses agreed that MBank purchased the

Frontier loan, but none of the witnesses had any personal knowledge

as to how MBank actually treated those funds.

3
 In December 1988, MBank released the Coxes's property from the

lien, but maintained all of its rights against the parties. By

March 1989, MBank was insolvent and the FDIC had placed it into

receivership. In May 1990, Light Bulb filed its reorganization

plan and pursuant to a deal arranged under this plan, MBank's

successor bank released Light Bulb and the Coxes from all liens.

On their 1987 tax return, the Coxes initially claimed no

deductions for their loans to Light Bulb nor for the foreclosed

property. On amended returns, however, the Coxes asserted that

they were entitled to a refund because the loans to Light Bulb

qualify as bad business debts. The Commissioner rejected their

deduction and found that the Coxes were deficient on their taxes

because they did not report their gain arising out of the

foreclosure sale of their property. The tax court agreed with the

Commissioner, disallowing the bad debt deductions and holding that

the Coxes realized a gain on the foreclosure. The Coxes now appeal

the tax court's decision to this Court.

II.

A finding of a deficiency by the Commissioner carries a

presumption of correctness, which the taxpayer may rebut by a

preponderance of the evidence.1 "[T]he Tax Court's determination

that a taxpayer has failed to come forward with sufficient evidence

to support a deduction is a factual finding subject to reversal

1
Portillo v. C.I.R., 932 F.2d 1128, 1133 (5th Cir.1991);
see also Potito v. C.I.R., 534 F.2d 49, 51 (5th Cir.1976) (per
curiam) (citing Welch v. Helvering, 290 U.S. 111, 54 S.Ct. 8, 78
L.Ed. 212 (1933)), cert. denied, 429 U.S. 1039, 97 S.Ct. 736, 50
L.Ed.2d 751 (1977).

4
only if found to be clearly erroneous".2

III.

Internal Revenue Code (I.R.C.) § 166(a)(1) (1987) allows

taxpayers to deduct any business debt that becomes wholly worthless

during the tax year in which the deduction is taken. The

Commissioner did not challenge the notion that the Coxes's loan to

Light Bulb was a business debt; rather, the only issue with

respect to this deduction is whether the debt became "wholly

worthless" in 1987.

The Coxes must prove that on January 1, 1987, the debt had

some value, which was totally lost by December 31 of that year.3

Although the Coxes assert that the Court should review the

worthlessness issue de novo, the clearly erroneous standard

applies. The worthlessness of a debt is a factual determination

made by the tax court;4 thus, it can be reversed only if the tax

court's finding that the debt was not wholly worthless is clearly

erroneous.5 The taxpayer must prove worthlessness of the debt by

a preponderance of the evidence.6

The primary point of contention regarding this debt, and the

part most closely scrutinized by the tax court, is whether the Cox

2
Portillo, 932 F.2d at 1134.
3
Estate of Mann, 731 F.2d 267, 275 (5th Cir.1984).
4
Id. at 276; see also Cole v. C.I.R., 871 F.2d 64, 66 (7th
Cir.1989); Hubble v. C.I.R., 42 T.C.M. (CCH) 1537, 1544, 1981 WL
11042 (1981).
5
Portillo, 932 F.2d at 1134.
6
Mann, 731 F.2d at 276.

5
loan became wholly worthless during 1987. The tax court found the

Coxes did not prove by a preponderance of the evidence that the Cox

loan lost all of its value. The record does not reveal that this

conclusion is clearly erroneous.

A debt becomes "wholly worthless when there are reasonable

grounds for abandoning any hope of repayment in the future".7 The

taxpayer must demonstrate an identifiable event that rendered the

debt worthless;8 the Coxes argue that Light Bulb's bankruptcy

served as the defining event. Indeed, "the debtor's serious

financial reserves, insolvency, lack of assets, ... [and the

creditor's] unsecured or subordinated status" are all factors

supporting the Coxes's claim of worthlessness.9 The debtor's

bankruptcy, however, is not enough by itself to establish

worthlessness.10

The Coxes further argue that Light Bulb was insolvent at the

time that it declared bankruptcy, relying on the company's

bankruptcy filing, which states that Light Bulb's debts exceeded

its liabilities by several hundred-thousand dollars. Additionally,

the Coxes rely on the testimony of the attorney retained by the

Coxes to handle Light Bulb's bankruptcy. During the tax court

proceedings, Borsheim explained:

I told them not to waste their time filing a proof of

7
Id.; see Tres.Reg. § 1.166-2(b) (1987).
8
Hubble, 42 T.C.M. (CCH) at 1544, 1981 WL 11042.
9
Cole, 871 F.2d at 67.
10
Hubble, 42 T.C.M. (CCH) at 1544, 1981 WL 11042.

6
 claim [of the Cox loan] at all. That there was no way that
that proof of claim would ever be paid in this bankruptcy
proceeding....

This was a case that was never going to pay 100 percent
to the unsecured creditors in the case; never. And as such,
the only way the Coxes were ever going to keep this
corporation was to convince the creditors in the case to vote
for the payment of a dividend that was going to be
substantially less than 100 cents on the dollar.

It was going to be perhaps ten or 20 cents on the dollar,
at most. And under those circumstances, the debtor can never,
with a straight face, say, well, creditor I am going to pay
you 20 cents on the dollar and, by the way, I want to keep my
company and I want to pay me 20 cents on the dollar.

That will never work in the real-day world. That claim
is worthless on the day that they filed bankruptcy.

According to the Coxes, this testimony, combined with the

insolvency and bankruptcy of the Light Bulb, provide sufficient

evidence of the claim's worthlessness.

Contrary to the Coxes's opinion, Borsheim's testimony does not

prove the worthlessness of the debt. Borsheim testified that

unsecured debtors could expect to be paid ten to twenty percent of

their claim. This uncontroverted testimony supports the

possibility that if the Coxes had filed their claim, then they

would have recovered some of that loan; thus, the tax court and

the Commissioner argue that the Cox loan was partially, not

totally, worthless. The Coxes counter by arguing that I.R.C. §

166(a) does not require the taxpayer to pursue collection of the

debt if "in the exercise of "sound business judgment' " there were

"reasonable grounds for abandoning any hope of repayment in the

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future".11 The Coxes interpret Borsheim's testimony to state that

the Coxes could not reasonably expect to recover their claim in the

Chapter 11 reorganization because no reorganization plan would be

approved in which the Coxes filed a claim.

The Coxes, in fact, did make a business judgment: they

surrendered their right to file a claim on the Cox loan in exchange

for the possibility of reorganizing and retaining control of their

company. In light of these facts, it does not seem that in all

probability an action to collect the debt would have been entirely

unsuccessful,12 provided that the Coxes were willing to surrender

control of their company.13 The Coxes, then, traded the opportunity

of recovery on the Cox loan for a chance to reorganize Light Bulb

while retaining ownership of it; as such, they cannot now attempt

to have their cake and to eat it too by keeping their company and

writing off a debt whose total worthlessness they have not

established.14

11
Mann, 731 F.2d at 276; see Tres.Reg. § 1.166-2(b); Cole,
871 F.2d at 67; Gladstone v. C.I.R., 59 T.C.M. (CCH) 303, 305,
1990 WL 34210 (1990).
12
Dustin v. C.I.R., 467 F.2d 47, 48 (9th Cir.1972).
13
See Cole, 871 F.2d at 67 (stating that one factor weighing
against worthlessness is the creditor's failure to press for
payment of the debt, especially when the creditor is in some way
affiliated with the debtor).
14
The Coxes also argue that they are entitled to a bad
business debt deduction to the extent that the foreclosure
proceeds were applied to Light Bulb's debts on which they were
guarantors. See Tres.Reg. § 1.166-9. Assuming that the Coxes
timely raised this issue, they still did not prove worthlessness
by a preponderance of the evidence. For the same reasons as with
the Cox loan, the tax court was not clearly erroneous in finding
that the Light Bulb debt for the amount of the proceeds became

8
 IV.

The Coxes next challenge the Commissioner's finding that the

Coxes received a taxable gain from the foreclosure sale of their

property. It is a well-established rule that a foreclosure sale

constitutes "a disposition of property" within the meaning of

I.R.C. § 1001.15 Under this provision, "the amount realized from

the sale or disposition of property shall be the sum of money

received plus the fair market value of property (other than money)

received".16 The Coxes do not contest this general rule governing

foreclosure sales; rather, they argue that the rule is

inapplicable in their situation because they received no gain from

the sale of their property and also because the foreclosure was

void.

The two arguments proffered by the Coxes are intertwined:

they assert that the foreclosure sale was void because they never

received the proceeds from the sale. Texas law holds that

foreclosure sales are invalid when the mortgagor is not paid the

proceeds of the sale in cash or, when the mortgagee is the

totally worthless in 1987. Furthermore, the Coxes failed to
prove the allocation of the proceeds between the Coxes's personal
debts and Light Bulb's debts. Finally, the Coxes also do not
satisfy this Court that any right of subrogation that they may
have had against Light Bulb also became totally worthless in
1987. See id. § 1.166-9(e)(2).
15
Helvering v. Hammel, 311 U.S. 504, 512, 61 S.Ct. 368, 372,
85 L.Ed. 303 (1941); Freeland v. C.I.R., 74 T.C. 970, 977, 1980
WL 4434 (1980). Nonjudicial foreclosure sales also qualify as
realizing events. Chilingirian v. C.I.R., 918 F.2d 1251, 1254
(6th Cir.1990).
16
I.R.C. § 1001(b).

9
purchaser, if the mortgagee does not credit the mortgagor's debt

with the amount of the purchase price.17 It is undisputed that the

Coxes never received cash from their foreclosure sale. The issue

is whether the proceeds were applied towards their indebtedness.

The Coxes contend that MBank never credited their debt with

the foreclosure price of their property, but rather purchased the

Frontier loan from Frontier. The Coxes point to certain evidence

to support this scenario. For example, according to certain MBank

records, MBank increased Light Bulb's indebtedness on its books by

the same amount that MBank paid to Frontier. Additionally, Harvey

Corn, the accountant handling Light Bulb's bankruptcy, testified

that the reorganization plan was based solely on the debtor's

ability to pay and did not consider the foreclosure proceeds.

Thus, denying that they received credit towards their indebtedness,

the Coxes argue that the foreclosure sale was void under Texas law.

In light of the evidence in the record, though, the tax court

was not clearly erroneous in finding insufficient evidence that the

foreclosure sale was invalid. As properly noted by the tax court,

the evidence is "unclear as to the extent to which Mr. Cox was

credited, which debts were credited, and when the debts were

credited".18 At the very least, the Coxes clearly received the

17
See Habitat, Inc. v. McKanna, 523 S.W.2d 787, 790
(Tex.App.1974).
18
Cox v. C.I.R., T.C.Memo 1994-189, at 16, 1994 WL 151311
(Apr. 28, 1994) (No. 7502-92). For instance, MBank's notation on
the check used to pay Frontier and the internal MBank memorandum
both suggest that MBank did pay off, not purchase, the Frontier
loan.

10
credit that they deserved when, in 1990, they were released from

their liabilities to MBank.19 This fact alone casts serious doubt

on the Coxes's argument.

The Commissioner's position is further supported by the fact

that even if MBank did not immediately credit the Coxes's debt, the

Coxes still had an undisputed right to a credit in the amount of

$490,000 when MBank paid that price at the foreclosure sale.20 The

foreclosure sale is the "definitive event that establishes gain or

loss"21 because at that point, the amount of debt of which the

taxpayer has been relieved is known and any gain or loss can be

computed.22 Once the foreclosure sale occurred, the sale price of

the property and the Coxes's adjusted basis in that property were

fixed, allowing for an accurate assessment of the Coxes's gain on

the transaction. The amount realized from the foreclosure sale

includes the amount of relieved indebtedness.23 In the Coxes's

case, then, they were relieved of $490,000 of debt when their

adjusted basis on the property was $451,831, leaving them with a

19
When the mortgagor's debt will be credited with the
proceeds of the foreclosure sale, the policies that require cash
buyers at foreclosure sales to pay the mortgagee at the time of
the sale or in a reasonable time thereafter do not apply.
Intertex, Inc. v. Cowden, 728 S.W.2d 813, 816 (Tex.App.1987).
20
Resolution Trust Corp. v. Westridge Court Joint Venture,
815 S.W.2d 327, 330 (Tex.App.1991). The deed of trust also
provided for the Coxes's debt to be credited in the event of
foreclosure.
21
Eisenberg v. C.I.R., 78 T.C. 336, 344-45, 1982 WL 11160
(1982).
22
Helvering v. Hammel, 311 U.S. at 512, 61 S.Ct. at 372.
23
See Freeland, 74 T.C. at 975-76, 1980 WL 4434.

11
taxable gain of $38,169.

The Coxes finally argue that there was no realizing event

because they never received credit for the sale of their property

and that when they were finally released from their liens, the

release was a direct result of the reorganization negotiations and

not the foreclosure. As explained above, however, the realizing

event was the foreclosure sale, at which point the Coxes's realized

gain is determinable. For these reasons, we conclude that the

Coxes are properly taxable on the gain that they received from the

sale of their property at the foreclosure sale.

V.

There was no clear error in the holdings of the tax court.

This Court AFFIRMS the tax court.

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