The Commissioner has determined a deficiency in income tax of $15,965.85 for the taxable year 1947. The deficiency is due to two adjustments to net income. Net income has been increased by two items described in the deficiency notice as follows:
Unallowable deductions and additional income:
(a) Loss on advance to U.S. and Panama Navigation Co. ................. $15,792.55 (b) Loss on advance to Cash and Carry Wholesale Grocery Co. ........... 34,750.00
Net income has been decreased by other items but they are not in issue. In explaining his disallowance of the two items set forth above, the Commissioner states in his deficiency notice as follows:
(a) It is held that losses resulting from advances made to the U.S. and Panama Navigation Company in the total amount of $15,792.55 are not allowable as a bad debt under the provisions of Section 23 (k) (1) of the Internal Revenue Code. It is further held that such amount is deductible as a nonbusiness bad debt under the provisions of Section 23 (k) (4) of the Internal Revenue Code.
(b) It is held that advances alleged to have been made to Cash and Carry Wholesale Grocery Company in the amount of $34,750.00 are contributions of capital and losses resulting therefrom are not deductible as bad debts under the provisions of Section 23 (k) (1) of the Internal Revenue Code. It is further held that you are not entitled to a nonbusiness bad debt deduction under the provisions of Section 23 (k) (4) of the Internal Revenue Code, inasmuch as the alleged loans did not become worthless prior to December 31, 1947. [The item in (b) of $34,750 has been reduced to the ultimate loss of $24,926.08 by stipulation.]
Petitioner has assigned error to the following action of the Commissioner:
The petitioner in his petition also assigned as error the failure of the Commissioner to allow a net operating loss carryback from the taxable year 1948 of $29,715.81 under section 23 (s) and section 122 of the Internal Revenue Code. No proof was offered at the trial on that point and the contention was not pressed in the briefs. The Court considers that petitioner has abandoned that issue.
(a) Disallowance of $15,792.55 advance to Navigation Company as a business bad debt.
(b) Disallowance of $24,926.08 advance to Cash and Carry as a business bad debt.
(c) Failure to determine that $39,800 of Cash and Carry stock became worthless and was a capital loss in 1947.
(d) Failure to allow certain items as business deductions. These items were originally taken as nonbusiness deductions on petitioner's 1947 return. They are as follows:
Interest ................................... $1,723.02 Rent ....................................... 290.00 Taxes ...................................... 616.37FINDINGS OF FACT.
The petitioner, J. T. Dorminey, a resident of Montgomery, Alabama, filed his individual income tax return for 1947 with the then collector of internal revenue for the district of Alabama.
The petitioner's occupation since 1931 has been that of a wholesale produce dealer in Montgomery, Alabama. He has been a partner in a number of partnerships or joint ventures and an officer and stockholder in several corporations organized for the purpose of obtaining, buying, and selling produce and other food items.
About 1942, petitioner commenced advancing money to brokers, to different business organizations in which he had a financial interest, and to others. He acquired the reputation of being a financial backer of those in whom he had confidence.
Petitioner's dealings from 1942 to 1952 can be classified mainly in two groups: (1) He made advances to produce brokers who would supply him with his needs at cost and then return the advance at the end of the season without the payment of interest. There were numerous brokers with whom petitioner dealt in this manner at various times. (2) Petitioner made advances and extended credit to partnerships and corporations in the food or produce business in which he was interested — usually a 50 per cent interest. In some of them he was the sole supplier of funds, while the other party or parties would operate the businesses. Most of them would either buy or sell their products from or to the petitioner. There were over 12 of such organizations with which he dealt in this manner.
Petitioner's economic motive in the transactions was related to his principal business of food distributing. Most of the advances or series of advances were made to a source of supply in order to procure food at lower cost, or to a wholesaler in order to provide increased sales outlet or, in a few instances of advances to partnerships or corporations, with a purpose of broadening his field of operations in the food sales and distribution business.
None, or substantially none, of the advances were for interest and few, if any, were evidenced by notes.
The U.S. and Panama Navigation Company (hereinafter referred to as Navigation) was formed in July 1946 to engage in the banana trade, with sources of supply in Central America and Cuba. Petitioner was interested in Navigation's formation, and became its vice president and a major shareholder by the purchase of $10,000 of stock. At that time, petitioner had a market for two carloads of bananas a week but could not obtain them because of economic conditions. One of petitioner's primary motives in helping to organize Navigation and in buying stock in it was to help insure a supply of bananas for his produce business.
Shortly after its organization in 1946, Navigation purchased a ship in New Orleans for $40,000. Navigation soon ran into unexpected difficulties. On its first voyage the ship became disabled in some manner and had to be laid up in drydock for about 3 weeks at additional expense. While in drydock, refrigeration machinery was installed at a cost of $4,500. During this time, the American crew was dismissed and a Colombian crew hired. A load of bananas was obtained in Panama and the ship broke down again soon after leaving port and the cargo was lost. On another occasion the ship had to be towed to Panama City at a cost of $3,000.
These and other difficulties caused Navigation to borrow funds from its shareholders and others. Petitioner personally guaranteed payment of a loan of $30,000 made by Alabama Discount Corporation to the extent of $10,000 and upon default of Navigation in 1947 paid $10,000 to the Alabama Discount Corporation. The total amount of petitioner's advances to Navigation was $15,792.55. Other stockholders made advances and endorsed Navigation's note of $30,000, assuming liability in varying amounts for payment of the loan.
The ship did make several trips and petitioner did receive a few carloads of bananas from Navigation. But the numerous difficulties combined to throw Navigation into bankruptcy. Petitioner's advances became totally worthless in 1947.
The Cash and Carry Wholesale Grocery Company, Montgomery, Alabama (hereinafter referred to as Cash Carry), was originally organized by petitioner as a sole proprietorship but was incorporated on August 31, 1946, with $40,000 capital stock. Petitioner purchased 400 shares of stock of $100 par value for $40,000 and gave his wife and daughter 1 share each. Other funds were procured on loans of $500 to $2,000 from retail grocers, in return for the petitioner's undertaking to have Cash Carry sell them groceries at reduced prices and to personally guarantee the loans. Additional financing was obtained in the form of credit at the First National Bank of Montgomery, Alabama, in the amount of $120,000. This credit from the bank was obtained upon a guarantee of 80 per cent of the account by Douglas Public Service Bond and Warehouse and upon petitioner's personal guaranty to the bank of the remaining 20 per cent. The petitioner also personally guaranteed the bonding company against loss.
Cash Carry did not turn out to be as profitable as expected. Petitioner, with the hope that Cash Carry would be profitable, made numerous advances to the corporation subsequent to incorporation and prior to the decision to liquidate. The amount of these advances that ultimately became worthless has been stipulated to be $24,926.08. The year when such $24,926.08 became worthless has not been stipulated. Petitioner contends it became worthless in 1947. Respondent contends that the year of worthlessness is 1948.
William E. Tucker, an experienced grocer, was employed as manager of Cash Carry about November 10, 1947. The first week after his employment commenced Tucker studied the operation and found it to be in a "mess." He found that about 5 per cent of the inventory was practically unsalable and that about 20 per cent of the inventory was hard stock, items packed during the war and difficult to sell. He concluded that another reason for the "mess" was the $1,540 bonding company expense. At this time Cash Carry owed the bank approximately $124,000 and owed suppliers about $50,000 to $60,000. It had an inventory of over $150,000, valued at current replacement cost. These amounts are exclusive of advances made by petitioner. Tucker concluded that Cash Carry was oversold on hard items and that it could not continue to operate in its present manner. He thereupon recommended to petitioner that Cash Carry be liquidated. In the latter part of November 1947, it was decided to liquidate.
Liquidation of Cash Carry commenced around December 1, 1947, at which time delivery service to customers was stopped and the number of employees reduced. Some of the inventory was returned to the sellers at cost and undelivered purchases were canceled. Creditors were notified of the liquidation and were informed that they would receive about 80 per cent of the amount due them.
Most of the inventory was disposed of by Christmas of 1947, but additional purchases of fast selling items were made until liquidation was completed in April or May of 1948.
Liquidation took place on a strong market and the outside creditors were paid off in full except for $5,000 or $6,000. Petitioner had a partial recovery on his advances in 1948. This recovery reduced his loss to $24,926.08, the amount stipulated here. The amount of $24,926.08 is exclusive of the $39,800 of capital stock claimed as a capital loss. On his 1948 return, petitioner reported: "Recovery on bad loans to Cash and Carry Who. Grocery $4,771.93." Petitioner's debt against Cash Carry did not become worthless in 1947.
Petitioner's stock in Cash Carry, which had a cost basis to him of $39,800, became worthless in 1947.
The petitioner deducted interest, rent, and taxes on his 1947 return as nonbusiness expenses; the respondent has allowed them as such. Of the deductions thus made by petitioner in his return, $1,723.02 was interest paid in the conduct of his business as a produce dealer; like wise rent of $290 and taxes of $616.37 were paid in the conduct of his business as a produce dealer.
OPINION.
BLACK, Judge:
Issue (a).The question involved with regard to the loss on the advances of $15,792.55 to Navigation is whether or not the loss on the debt was incurred in trade or business. The petitioner contends it is a business bad debt deductible under section 23 (k) (1). The respondent contends it is a nonbusiness bad debt deductible under section 23 (k) (4) only. The applicable provisions of the Internal Revenue Code of 1939 and Treasury Regulations 111 are printed in the margin.
Internal Revenue Code of 1939:
SEC. 23. DEDUCTIONS FROM GROSS INCOME.
(k) BAD DEBTS. —
(1) GENERAL RULE. — Debts which become worthless within the taxable year; or (in the discretion of the Commissioner) a reasonable addition to a reserve for bad debts; and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction. * * * [Emphasis supplied.]
* * * * * * *
(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.
Regulations 111:
SEC. 29.23 (k)-6. NON-BUSINESS BAD DEBTS. * * *
The character of the debt for this purpose is not controlled by the circumstances attending its creation or its subsequent acquisition by the taxpayer or by the use to which the borrowed funds are put by the recipient, but is to be determined rather by the relation which the loss resulting from the debt's becoming worthless bears to the trade or business of the taxpayer. If that relation is a proximate one in the conduct of the trade or business in which the taxpayer is engaged at the time the debt becomes worthless, the debt is not a non-business debt for the purposes of this amendment.
Whether such bad debt loss was incurred in trade or business is essentially a question of fact. The petitioner was a large shareholder and vice president of the debtor corporation. He was engaged in the produce business and had a market for about two carloads of bananas a week, but he could not obtain bananas because of economic conditions. Navigation was formed to bring bananas here from Central America and Cuba. Petitioner invested in Navigation for the purpose of obtaining bananas. The advances were incidental to and proximately related to his produce business. The resulting bad debt loss was incurred in trade or business and is deductible under section 23 (k) (1). See Commissioner v. Stokes Estate, (C. A. 3, 1953) 200 F.2d 637.
Whether or not the petitioner, by his financing activities, was engaged in the money-lending business need not be determined since the bad debt loss was incidental to and proximately related to his produce business. Cf. Robert Cluett, 3d, 8 T.C. 1178 (1947); Stuart Bart, 21 T.C. 880 (1954); and George J. Schaefer, 24 T.C. 638 (1955).
Issues (b) and (c).
The questions involved regarding the advances to Cash Carry are: (1) Whether the advances were contributions to capital or loans, (2) did they become worthless in 1947, and (3) if they were loans was their worthlessness incurred in trade or business?
See I. R. C. 1939, sec. 23 (k) (1), supra, note 2.
See I. R. C. 1939, sec. 23 (k) (4), supra, note 2.
The petitioner contends that the advances were business loans that became worthless in 1947. The respondent contends that they were contributions to capital rather than loans, or nonbusiness loans, and did not become worthless in 1947.
Whether the advances were contributions to capital or loans is essentially a question of fact. The petitioner had invested $40,000 in the stock of Cash Carry. The record does not reveal the existence of any disproportionate debt at the time of incorporation. Cash Carry was obviously not undercapitalized in its inception. The advances made by petitioner were made subsequent to incorporation and prior to the decision to liquidate. His intent was to create loans. The business was expected to prosper and repayment was contemplated. The shortage of working capital resulted from excessive purchases of hard stock, but the petitioner was apparently unaware of this condition. There are facts tending to support each contention but the substantial amount invested as equity capital and the intention of the parties lead us to conclude that the advances constitute loans rather than contributions to capital. The fact that the petitioner was for all purposes a sole stockholder, see Van Clief v. Helvering, (C. A., D.C., 1943) 135 F.2d 254, 256, or that the advances were on open account, see Maloney v. Spencer, (C. A. 9, 1949) 172 F.2d 638, 641, does not require a different conclusion.
We do not reach the question of whether the loans to Cash Carry were business or nonbusiness loans since we find that they did not become worthless in 1947. Just how much petitioner's debt against Cash Carry there was at the end of 1947 does not appear from the record. Petitioner on his return for 1947 claimed a bad debt loss of $34,750 against Cash Carry and, as we have already stated, the Commissioner in his determination of the deficiency disallowed it.
On the last day of 1947, it was clear that the debt was not wholly worthless. Cash Carry was in the process of liquidation. The market was strong and fast selling items were still being purchased in order to reduce the loss. Petitioner had not wholly subordinated his loans to those of other creditors. He recovered a portion of his debt in 1948 while other creditors were not paid in full. These factors tend to show value rather than worthlessness in 1947. See F. Sitterding, Jr., 20 T.C. 130 (1953). The ultimate loss has been stipulated to be $24,926.08, but that takes into account the 1948 recovery. It constitutes only a portion of the debt due on December 31, 1947.
Whether the petitioner would have been entitled to a partial bad debt deduction in 1947 if claimed need not be decided. Petitioner has neither pleaded nor proved compliance with the statutory conditions necessary to the allowance of a deduction for a partially worthless debt. However, we do hold that the petitioner's capital stock of Cash Carry in the amount of $39,800 became worthless in 1947. An excess of liabilities over assets does not necessarily render the stock worthless. Van Clief v. Helvering, supra. But at the end of 1947 liquidation was under way and it was clear that all of the creditors, including petitioner, could not be paid in full. It perforce follows that the equity investment in Cash Carry was worthless. It is, therefore, deductible as a capital loss under section 23 (g) of the 1939 Code. Richard M. Drachman, 23 T.C. 558, 563-564 (1954). The Drachman case seems to be clearly in point and we follow it here.
See I. R. C. 1939, sec. 23 (k) (1), supra, note 2.
Issue (d).
One of petitioner's assignments of error was that the Commissioner failed to allow as business expenses $1,723.02 interest, $290 rent, and $616.37 taxes. Petitioner alleges that these expenses were incurred and paid in 1947 in his business as a produce dealer.
These deductions as well as others claimed, which were clearly not business deductions, were listed in the deductions claimed on page 3 of petitioner's income tax return for 1947. These deductions were from adjusted gross income, not deductions in arriving at adjusted gross income. Petitioner now claims, as he has a right to do under his pleadings, that these deductions should have been taken in arriving at adjusted gross income.
What difference this treatment will make in petitioner's taxable net income for 1947 we are unable to determine without making a recomputation under Rule 50. Respondent in his brief says it will make no difference. It may be this is so. However, it appears that the deductions which we have enumerated are allowable as business deductions from gross income, in computing petitioner's adjusted gross income, and we hold they should be allowed as business deductions from gross income as petitioner contends.
Decision will be entered under Rule 50.
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