United States Court of Appeals,
Fifth Circuit.
No. 94-40709.
John C. and Jean P. SMITH, Petitioners-Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
Sept. 25, 1995.
Appeal from the Tax Court of the United States.
Before POLITZ, Chief Judge, REAVLEY and EMILIO M. GARZA, Circuit
Judges.
POLITZ, Chief Judge:
John C. and Jean P. Smith, husband and wife, appeal the
judgment of the tax court determining a deficiency of $123,930 in
their joint income tax for 1987. We affirm.
Background
In 1981 John Smith and Robert L. Bennett incorporated Smith-
Bennett Properties, Inc. for the purchase and development of real
estate. Three years later the corporation and several other
investors formed a joint venture, Spicewood Springs Venture, to
purchase and develop an 11.4 acre tract of undeveloped property.
The venture purchased the tract from Austin Financial Corporation,
a corporation owned by Gary Bird, giving in payment a $367,314 note
to Bird, secured by a second mortgage on the property, and assuming
the balance of an outstanding $750,000 priming mortgage note held
by United Bank of Texas. All venture participants gave personal
guaranties for the assumed note.
Smith eventually became the sole shareholder in the Smith-
1
Bennett corporation which, ultimately, became the sole member of
the Spicewood joint venture. The restructuring resulted in Smith
becoming the sole guarantor of the assumed mortgage note.
In 1986 the value of the Spicewood property declined
precipitously. In 1987 Smith informed United Bank that neither he
nor the venture could pay the note. He suggested that United Bank
foreclose on the property and, after obtaining financing from
another lender, he proposed to satisfy the indebtedness by bidding
the amount of his guaranty at the foreclosure sale. United Bank
agreed to this plan and Smith sought financing from First City
National Bank of Austin for the approximate $750,000 owed on the
note.
In April 1987 United Bank instituted foreclosure proceedings.
A problem developed when First City refused to complete the loan
primarily because of the unavailability of title insurance due to
the legal concern that Smith's purchase at the foreclosure sale
would not eliminate Bird's security position on the property. On
May 5, 1987 Smith placed the joint venture into Chapter 11
bankruptcy, thus terminating the foreclosure proceedings. Within
a matter of days United Bank was taken over by the Federal Deposit
Insurance Corporation.
Smith successfully sought a public sale of the Spicewood tract
by the bankruptcy court, a sale which, by its terms, would leave
the property free of all encumbrances. Smith also received court
approval to bid personally on the property. As such a sale would
cancel the Bird lien and allay concerns of title insurers, and
2
secure for First City a priming mortgage position, it agreed to
loan Smith $750,000 for his "purchase" of the Spicewood property.
Smith submitted the only proposal at the bankruptcy sale, bidding
$837,316.40, the exact sum needed to pay the mortgage note assumed
by the joint venture. The bankruptcy sale was approved and
consummated.
Based on their belief that a significant portion of the bid
was an unrecoverable satisfaction of John Smith's guaranty
obligation, the Smiths claimed a nonbusiness bad-debt deduction of
$637,874 on their 1987 joint income tax return.1 The Internal
Revenue Service rejected the deduction, maintaining that the form
of the transaction, a purchase, controlled its characterization for
tax purposes, and that any claimed loss was necessarily speculative
until resale of the property. The IRS assessed a deficiency of
$123,930.43.
The matter was taken to the tax court which rejected the
contention that the foregoing scenario constituted the
unrecoverable payment of a guaranty and held that regardless of the
form of the transaction, its substance was merely the refinancing
of the originally assumed mortgage note. The tax court found no
actual loss by the Smiths, declined the deduction, and confirmed
the deficiency. The Smiths timely appealed.
Analysis
The Smiths challenge the adverse ruling of the tax court on
1
The deduction is the difference between the total cost of
the bankruptcy sale transaction, $872,874, less a credit of
$235,000, the then-estimated worth of the Spicewood property.
3
their claim of a nonbusiness bad-debt deduction arising out of
their acquisition of the Spicewood tract. We review tax court
factual findings under the clearly erroneous standard2 and legal
conclusions de novo.3
Typically, a taxpayer cannot incur a deductible loss upon the
mere purchase of property for the transaction, at that point, is
open, remaining so until a closure, such as a resale, occurs.4
When such an event occurs any resulting loss may qualify as an
allowable deduction.5 If the bankruptcy proceeding through which
Smith received title is regarded as a sale, the Smiths may not
claim a deduction until the property is resold at a loss and they
otherwise qualify.
If, on the other hand, the transaction is treated as
satisfaction of a guaranty, the Smiths may deduct, as a short-term
capital loss, any payment which is nonrecoverable.6 The deduction
is allowed to the extent the taxpayer's satisfaction of a guaranty
cannot be recovered from the primary obligor.7 The Smiths maintain
2
Curtis v. Commissioner of Internal Revenue, 623 F.2d 1047
(5th Cir.1980).
3
Harris v. Commissioner of Internal Revenue, 16 F.3d 75 (5th
Cir.1994).
4
26 U.S.C. § 1001 (1994).
5
San Antonio Savings Association v. Commissioner of Internal
Revenue, 887 F.2d 577 (5th Cir.1989).
6
26 U.S.C. § 166(d)(1) (1994).
7
Putman v. Commissioner of Internal Revenue, 352 U.S. 82, 77
S.Ct. 175, 1 L.Ed.2d 144 (1956); Garner v. C.I.R., 987 F.2d 267
(5th Cir.1993).
4
that the amount paid beyond the fair market value of the Spicewood
property is not recoverable because of the insolvency of the joint
venture and the Smith-Bennett corporation.
A correct characterization of the subject transaction is
critical to a proper determination of the tax consequences. It is
not meaningfully disputed that the form of the transaction at issue
was that of a sale. The Smiths maintain that the form should yield
to the substance of the transaction. Considering that the price
paid exceeded the fair market value of the property and equaled the
amount owed by Smith under his personal guaranty,8 the Smiths
contend that the economic reality of the transaction was
satisfaction of the guaranty and they insist that this reality
should control the tax consequences.
Although obviously important, the professed economic reality
of a transaction is not a "talisman" which blinds the taxing
authorities to other relevant factors and dictates the tax
consequences.9 Ordinarily, a taxpayer cannot "avoid the
consequences of his agreement by showing that the "economic
realities' were otherwise."10 The rule, rather, is that taxpayers
are bound to the form of the transaction that they have chosen, as,
while a taxpayer is free to organize his affairs as he
8
The record contains no evidence that the guaranty was
actually invoked.
9
Spector v. Commissioner of Internal Revenue, 641 F.2d 376
(5th Cir.), cert. denied, 454 U.S. 868, 102 S.Ct. 334, 70 L.Ed.2d
171 (1981).
10
Id. at 386, citing Harvey Radio Lab., Inc. v. Commissioner
of Internal Revenue, 470 F.2d 118, 120 (1st Cir.1972).
5
chooses, nevertheless, once having done so, he must accept the
tax consequences of his choice, whether contemplated or not,
and may not enjoy the benefit of some other route he might
have chosen to follow but did not.11
As an exception to this rule, a taxpayer may argue substance over
form "when necessary to prevent unjust results,"12 and when proof
is offered "which in an action between the parties would be
admissible to alter that construction or to show its
unenforceability because of mistake, undue influence, fraud,
duress, etc."13
11
Commissioner of Internal Revenue v. National Alfalfa
Dehydrating & Milling Co., 417 U.S. 134, 94 S.Ct. 2129, 40
L.Ed.2d 717 (1974).
12
Adobe Resources Corp. v. United States, 967 F.2d 152, 156
(5th Cir.1992).
13
Spector, 647 F.2d at 382, citing Commissioner of Internal
Revenue v. Danielson, 378 F.2d 771, 775 (3d Cir.), cert. denied,
389 U.S. 858, 88 S.Ct. 94, 19 L.Ed.2d 123 (1967). The Smiths
argue that Spector's requirement of agreement-varying proof is
inapplicable to "situations in which the government will never
face conflicting claims." Comdisco, Inc. v. United States, 756
F.2d 569, 578 (7th Cir.1985). They claim that, as the other
party to this transaction was a government agency (the FDIC,
acting as recipient of the funds generated from the sale), there
is no threat of two conflicting characterizations of the
transaction allowing both parties to obtain favorable tax
treatment, thus defeating tax payment.
We are not persuaded. The spectre of the conflicting
claims exists herein. The record reflects that Smith-
Bennett's 1987 tax return contained a deduction for a
capital loss arising from a sale of the Spicewood property
for $560,000. Although the Smiths now claim this entry to
be a mistake, it had the net effect of creating a
now-uncollectible tax deficiency that inured to Smith's
benefit as sole stockholder. See 26 U.S.C. § 6501(a)
(1994). Thus, as there already have been conflicting
constructions of the transaction so as to receive favorable
tax treatment for both, the threat of a whipsaw has already
materialized, rendering Spector's proof requirement
applicable.
6
The record contains no admissible proof sufficient to vary
the form of the instant agreement. The Smiths do not demonstrate
any conditions that render the sale agreement involuntary.
Claiming that they styled this transaction a purchase only to
obtain financing necessary to pay the pending guaranty, the Smiths
essentially argue that economic duress compelled their choice of
the form. To show economic duress sufficient to warrant the
ignoring of the form, the Smiths must prove wrongful acts causing
their financial distress and effectively coercing their use of the
purchase form.14 The record before us contains no wrongful acts
committed by any other party connected to the court-ordered sale,
let alone any leading to Smith's unwilling entry into this sales
transaction. Indeed, the record supports the tax court's finding
that Smith actively pursued a voluntary purchase arrangement which
was quite advantageous. No unjust results accrued to the Smiths by
their being bound to the form of this transaction.15
We also agree with the tax court's conclusion that in
obtaining the property at a court-ordered public sale Smith
14
See Palmer Barge Line v. So. Petroleum Trading Co., 776
F.2d 502 (5th Cir.1985) (applying Texas law); Lee v. Hunt, 631
F.2d 1171 (5th Cir.1980), cert. denied, 454 U.S. 834, 102 S.Ct.
133, 70 L.Ed.2d 112 (1981) (applying Texas law); Tower
Contracting Co., Inc. of Tex. v. Burden Bros., Inc., 482 S.W.2d
330 (Tex.Civ.App.—Dallas 1972, writ ref'd n.r.e.).
15
The Smiths also contend that a taxpayer may invoke
substance over form where "his tax reporting and actions show an
honest and consistent respect for the substance of the
transaction." Weinert's Estate v. Commissioner of Internal
Revenue, 294 F.2d 750, 755 (5th Cir.1961). Considering their
inconsistent reporting of the disputed transaction in their
personal and corporate tax returns, the Smiths' reliance upon
Weinert is misplaced.
7
improved his position as owner of the property. The court
correctly noted that because of his sole control over both Smith-
Bennett and the joint venture, Smith was the de facto owner of the
property during this entire scenario. By the purchase in his
individual capacity at the bankruptcy sale he transformed his de
facto ownership into the superior de jure ownership. Further,
Smith's decision to cast this transaction as a purchase conferred
the additional beneficial effect of washing out Bird's $367,000-
plus lien which would have reduced the value of his ownership
dramatically.
Even assuming that Smith's sole motivation was payment of the
pending guaranty, his use of the bankruptcy sale legal vehicle made
it possible for him to get the financing required to satisfy that
obligation. The record reflects that in light of his precarious
economic position, the obtaining of a loan from First City was
essential to payment of the guaranty. As a direct result of the
cancellation of the Bird mortgage position via the bankruptcy sale,
the concerns of the title insurer were assuaged and title insurance
became available. It was only then that First City agreed to loan
Smith the funds necessary for the purchase and for the concomitant
elimination of the potentially ruinous personal liability that the
guaranty agreement posed.
Smith's "purchase" also resulted in a favorable change in the
terms of indebtedness relating to his guaranty. Under the terms of
the guaranty and the note it secured, Smith would have been
required to pay upon demand after acceleration of the principal
8
obligation, including over 15% interest. By using the bankruptcy
sale process, Smith was able to obtain a loan from First City that
replaced his guaranty obligation with an obligation providing a
longer repayment term at a lower interest rate. Further, by this
substitution Smith escaped the contractual liability for added
costs inherent in collection of the guaranty.
Finally, Smith's use of the bankruptcy sale process allowed
him to circumvent the costly and dilatory state procedures required
for a guarantor to receive title to immovable property securing the
principal obligation. United Bank, and the successor FDIC, had,
under the terms of the mortgage note, the right to demand payment
and to foreclose upon the Spicewood property when the joint venture
failed to pay as agreed. Under basic principles of subrogation, if
the guaranty had been formally invoked and satisfied, Smith would
have possessed these rights.16 By purchasing the property at the
bankruptcy sale he received a benefit unavailable to a subrogating
guarantor, i.e., the immediate receipt of title without resort to
time-consuming foreclosure, at which Smith, just as any other
similarly-situated mortgagee, would have been required, after due
notice, to bid the amount owed pursuant to his guaranty before
receiving title.17
Being persuaded beyond peradventure that the benefits
16
Farm Credit Bank of Texas v. Ogden, 886 S.W.2d 305
(Tex.App.—Houston [1st Dist.] 1994, no writ).
17
See, e.g., Tarrant County Savings Association v. Lucky
Homes, Inc., 390 S.W.2d 473. (Tex.1965); Sandel v. Burney, 714
S.W.2d 40 (Tex.App.—San Antonio 1986, no writ).
9
surrounding Smith's decision to structure this transaction as a
purchase demonstrate that "reasonable men, genuinely concerned with
their economic future, might bargain for such an agreement,"18 we
find no unjust results that require derogation from the
well-settled rule that the form of a transaction controls its tax
consequences. The equities militate against the Smiths. No
capital loss-based deduction may be claimed until the property is
resold and the requisite elements for that deduction are met and
the Smiths appropriately qualify.
Accordingly, the judgment of the tax court disallowing the
deduction and finding a $123,930 deficiency in the Smiths' 1987 tax
is AFFIRMED.
18
Sonnleitner v. Commissioner of Internal Revenue, 598 F.2d
464, 467 (5th Cir.1979).
10