Bachrach v. Commissioner

Alfred R. Bachrach, Petitioner, v. Commissioner of Internal Revenue, Respondent Bachrach v. Commissioner Docket No. 26810 United States Tax Court 18 T.C. 479; 1952 U.S. Tax Ct. LEXIS 173; June 10, 1952, Promulgated *173 Decision will be entered under Rule 50. 1. Petitioner and his three associates over a period of years organized corporations to hold and manage tenement properties. They followed a pattern of undercapitalizing corporations and, pursuant to agreement after incorporation, advanced funds in proportion to their holdings with which to acquire the properties sought and for additional working capital. The properties usually had one or more mortgages running from two to five years which were seldom paid out, the intention of the stockholders being, after operation costs, to divide proportionately the income of the corporation. The advances were carried on the books as open accounts or as "loans payable." No note or certificate was given, no interest was paid or was to be paid and there was no time limitation within which advances were to be repaid. The investments were considered temporary and after liquidation of one corporation reinvestment was made in a similar corporation. Held, under the facts, that petitioner's advances to E corporation were capital contributions and his loss upon E's liquidation is not deductible in full as a bad debt, but is deductible as a capital loss subject *174 to the limitations of section 117 of the Internal Revenue Code. Isidor Dobkin, 15 T. C. 31, affd. per curiam(C. A. 2), 192 F. 2d 392, followed. 2. Petitioner and his associates caused their D corporation to make a loan on a parcel of its property, but were required by the mortgagee to personally guarantee the payment of the mortgage. Upon opportunity to sell the property, which the purchaser desired to be clear of the mortgage and the mortgagee, not willing to accept satisfaction of the loan, petitioner and associates, in order to make the sale, substituted their personal notes for the corporate note and became primarily liable for the corporate indebtedness in proportion to their respective interests. Held, that petitioner, being on a cash basis, and having paid out nothing on his liability in the tax year, made no "constructive payment" on the corporate mortgage and is not entitled to the bad debt deduction claimed. Helvering v. Price, 309 U.S. 409; Eckert v. Burnet, 283 U.S. 140. Alan Demar, Esq., for the petitioner. Michael J. Kenny, Esq., for the respondent. Turner, Judge. TURNER *479 The respondent determined a deficiency in income tax against petitioner for the year 1945 in *175 the amount of $ 1,647.80. Petitioner has not taken exception to all the adjustments made by respondent to his *480 income tax liability and concedes a deficiency of $ 532.05, leaving in controversy a deficiency in income tax in the amount of $ 1,115.75. The two questions presented are (1) whether a claim of loss resulting from the worthlessness of advances to a corporation is deductible as a business bad debt or as a long term capital loss, and (2) whether petitioner sustained a deductible loss when he guaranteed the payment of a corporate mortgage by giving his promissory note. FINDINGS OF FACT. Some of the facts have been stipulated and are found accordingly. Petitioner is an individual and a resident of New York City. He filed his income tax return for 1945 with the collector of internal revenue for the third district of New York. He is engaged in the practice of public accounting in New York City and filed his return on the cash receipts and disbursements basis. Petitioner and his associates, since 1925, have organized forty to fifty corporations in which titles to respective pieces of property were vested. Petitioner's associates were usually his two brothers and one Ira Rosenstock, *176 a close personal friend, who, with petitioner's father, had organized similar corporations over a period of several years prior to 1925. Usually the four composed the investing group but occasionally the group varied by the addition of another member. A piece of property for sale could be found by any one of the group and, after discussion, if it was deemed desirable, the property was purchased. Property located in the Harlem district of New York City was preferable, although it was considered a greater business risk because of the class of tenants in that district and the treatment the property received from them. The property was more desirable if there were one or more mortgages on it. The properties were purchased subject to the mortgages thereon or by the assumption of the mortgages. Mortgages on the property acquired ran from two to five years and were seldom paid by the corporation holding the property. Sometimes, due to an amortization contract, a corporation paid part of the mortgage, but the properties were not considered permanent investments. The proportionate interest of each member of the group in the corporations formed varied at times, but usually Rosenstock's *177 interest was 60 per cent and petitioner and his brothers had equal interests in 40 per cent of the investment. It was agreed that each member would advance in proportion to his stockholdings whatever other money the corporation might need, and payments from the corporation to the stockholders were made in the same proportions. The group attempted fairly to estimate normal operating expenses before any substantial amount of return was received and the corporation was capitalized *481 for that amount. Such expenses as a superintendent's salary, coal, insurance, interest, and taxes might be paid before rent income would cover them. The capitalization of the corporations ranged from $ 1,000 to $ 2,000. The amount invested in the stock of the respective corporations was never sufficient to cover the purchase price of the property bought. The stockholders under their agreement with each other, and after the formation of a corporation, advanced the necessary funds which, with or without the capital paid into the corporation, composed the purchase price of the property acquired for the corporation. In some instances all the purchase price was not paid at once but payment was extended under *178 a purchase contract. Some advances might be made for other reasons. No note, certificate, or anything was given by the corporations to substantiate the advances made by petitioner and his associates nor was the time fixed within which the advances were to be repaid. No interest was collected by them from the corporations on the advances they made. The advances were shown on the books of the corporation as open accounts or "loans payable." When a corporation showed earnings the stockholders would start withdrawing the money they had advanced and thereby reduce their risks. In anticipation of a possible foreclosure of the mortgage on the corporate property the stockholders would repay themselves as quickly as possible. During the year 1930 petitioner and his associates organized a corporation under the name of Est Realty Company, Inc., sometimes hereinafter referred to as Est Company. They invested $ 1,200 in the capital stock of the company, which stock was held in the following proportions: Stockholder Per cent Ira Rosenstock [50] Harold D. Bachrach 16 2/3 Alfred R. Bachrach 16 2/3 Herbert H. Bachrach 16 2/3 It was estimated that it would take $ 1,200 to run the property to be acquired. The *179 stockholders had to advance a good deal more to buy the property that was purchased. Est Company purchased two parcels of tenement property in 1930 which were respectively located at 46 East 132d Street and 121 West 134th Street. The former was disposed of in 1934 and the latter was sold in February 1945. These properties were the only capital assets ever held by Est Company. It is not shown what was the purchase price of the two parcels of property, their market value, nor the number and amount of the mortgages, if any, that existed *482 on the properties either at their acquisition or on their disposal. Petitioner had been unable to locate the books of Est Company since some renovation was made in the office in 1945. Est Company became defunct November 30, 1945. Beginning at the fiscal year ended November 30, 1930, and through the fiscal year ended November 30, 1945, the books of the company (by stipulation of parties) reflected the following payments and repayments, payments and repayments being in direct proportion to the stockholdings of the stockholders: Year ended Nov. 30 payments to Corporation $ 9,907.00 1930 -- repayments 1,874.66 8,032.34 payments to Corporation 100.00 1931 -- 8,132.34 repayments 400.00 7,732.34 payments to Corporation 7,176.97 1934 -- 14,909.31 repayments 802.00 14,107.31 payments to Corporation 7,565.00 1935 -- 21,672.31 repayments 7,089.04 14,583.27 1936 -- payments to Corporation 705.00 15,288.27 1937 -- repayments 100.00 15,188.27 1939 -- repayments 607.00 14,581.27 1945 -- payments to Corporation 225.00 Net Total on November 30, 1945 $ 14,806.27 *180 None of the money advanced to the company was used to pay off its mortgage or mortgages. It is not shown for what purposes the above payments were made. *483 Petitioner's share of the net total payment, $ 14,806.27, on November 30, 1945, was $ 2,467.71, which was in direct proportion to his stockholdings. Petitioner claimed a business bad debt in the amount of $ 2,467.71 on his 1945 income tax return. Petitioner was not in the business of lending money to corporations. The advances he made to Est Company constituted a capital investment which became worthless in 1945. The petitioner and his three associates caused one of their organizations, Dune Realty Corporation, to borrow $ 3,500 on a piece of its property. The lender was not satisfied to have the corporation's mortgage but required the four individuals, who were the stockholders of the corporation, to personally guarantee the payment of the mortgage. Later when the corporation was about to sell the property and the prospective purchaser wanted the property clear of the mortgage, the mortgagee would not accept payment of the indebtedness, when approached on the matter, as he desired to continue to receive the interest of 6 per cent *181 on the loan. In order to make the sale petitioner and his associates executed their promissory notes, in 1945, for the unpaid balance of the mortgage, petitioner's share being $ 525. Petitioner paid nothing in 1945 for the note. The real estate was released from the lien and petitioner claimed a loss deduction of $ 525 in his income tax return. In the statement to the notice of deficiency respondent made the following explanation of adjustments: (a) It is held that the deduction of $ 2,467.71, claimed for a loss resulting from the worthlessness of moneys paid to the Est Realty Corporation, represents a long-term capital loss which reduces your reported capital gains to the extent of $ 1,233.85. (b) Deduction of $ 525.00 claimed for loss on a guarantee of a mortgage disallowed for lack of substantiation. OPINION. Petitioner contends that he is entitled to the deductions of both amounts for the reasons that the sum of $ 2,467.71 was a business bad debt that resulted from the worthlessness of alleged loans which he had made to that extent to the Est Company and the amount of $ 525 was a loss he had sustained by giving his promissory note in guaranty of payment of that much of a mortgage *182 owed by Dune Realty Corporation, which resulted in the corporation's property being released from the mortgage. The first question is whether the advances were contributions to capital or loans. If they were loans, we then have the question of whether they were business or nonbusiness debts, the answer to which in turn depends on whether petitioner was in the business of making loans to corporations, as he contends. *484 Section 23 (k) (1) and ( 4), Internal Revenue Code 1*183 permits, respectively, deductions of business bad debts and nonbusiness debts, while capital loss deductions are permitted by section 23 (g), but only to the extent as provided in section 117, the applicable subsections of which are (a) (1) and (b), 2*184 *185 under which respondent made his determination. The parties are at issue on whether the advances involved are to be treated as business bad debts or contributions to capital. In order that the sum of $ 2,467.71 be allowed as a business bad debt deduction, petitioner must show not only that his advances to Est Company were loans and not contributions to capital but that he was in the business of making loans to corporations. Petitioner claims that he had been in the business of organizing corporations and making loans to them; that he had been so engaged *485 over a long period of years; that it was his intention to establish a creditor-debtor relationship with the corporations, as well as a proprietary interest in them; and, that that intention, as well as the low capitalization of the corporations, was due to the risk involved in handling the properties acquired. Petitioner relies on Vincent C. Campbell, 11 T. C. 510, and claims the facts of that case are on all fours with the facts herein. However, we think not. In it the parties were agreed that a debt was owing to the taxpayer. The question was whether the debt was a business or a nonbusiness debt under section 23 (k) (4). Here we *186 have a dispute as to there being a debt, and our question arises under section 23 (k) (1). Est Company was organized with a small amount of capital, which was inadequate for the carrying out of its purpose of acquiring certain property or for its operations. The stockholders knew so in advance of forming Est Company, and followed their usual pattern and their agreement by advancing the necessary funds so that the purpose of the company could be carried out. Their advances were made in the same proportion as their original capital contributions, which invites scrutiny of the true nature of the stockholders' advances to the company. Wilshire & Western Sandwiches, Inc. v. Commissioner, 175 F. 2d 718. There was no evidence of a loan, such as a note, no provision for, or expectation of, the payment of interest and no fixed date for the repayment of the so-called "loans." See United States v. South Georgia Railway Co., 107 F. 2d 3; Daniel Gimbel, 36 B. T. A. 539; and Commissioner v. O. P. P. Holding Corporation, 76 F. 2d 11, affirming 30 B. T. A. 337. Petitioner's only security was the corporation itself and that was speculative. It thus appears that petitioner was not a maker of loans *187 but was an investor. A similar question to the one we have here was presented in Isidor Dobkin, 15 T. C. 31, affd. per curiam (C. A. 2), 192 F. 2d 392. In it the taxpayer and three associates organized a corporation to hold and manage a parcel of New York City business property. Approximately $ 27,000 was required to finance the purchase over and above outstanding first and second mortgages. Dobkin and his associates each paid $ 7,000, of which $ 500 was designated capital stock and the remaining $ 6,500 was set up on the corporation's books as "Loans Payable." When additional working capital was required, the equality of investment was maintained by equal contributions. It was held that the entire amount paid in by Dobkin was intended to be risk capital and his loss upon liquidation of the corporation was not deductible in full as a bad debt but was deductible as a capital loss subject to the limitations of section 117. Language apropos to the instant case appears in the opinion, at page 32, as follows: Petitioner's contention that the funds which he paid in to Huguenot should be treated as loans so as to entitle him to a bad debt deduction on the corporation's *486 liquidation runs *188 squarely into our decision in Edward G. Janeway, 2 T. C. 197, affd., 147 Fed. (2d) 602. Ordinarily contributions by stockholders to their corporations are regarded as capital contributions that increase the cost basis of their stock, thus affecting the determination of gain or loss on ultimate dispositions of the stock. Harry Sackstein, 14 T. C. 566. Especially is this true when the capital stock of the corporation is issued for a minimum or nominal amount and the contributions which the stockholders designate as loans are in direct proportion to their shareholdings. Edward G. Janeway, supra. When the organizers of a new enterprise arbitrarily designate as loans the major portion of the funds they lay out in order to get the business established and under way, a strong inference arises that the entire amount paid in is a contribution to the corporation's capital and is placed at risk in the business. Cohen v. Commissioner, 148 Fed. (2d) 336; Joseph B. Thomas, 2 T. C. 193. The formal characterization as loans on the part of the controlling stockholders may be a relevant factor [n1] but it should not be permitted to obscure the true substance of the transaction. Sam Schnitzer, 13 T. C. 43, 60. Footnote *189 one states: The determinative intent described in Wilshire & Western Sandwiches, Inc., 175 Fed. (2d) 718, must necessarily be the objective intent disclosed by all the pertinent factors in the case and not the formal manifestation of intent declared by the taxpayer. Cf. O'Neill v. Commissioner, 170 Fed. (2d) 596, certiorari denied, 336 U.S. 937. The opinion also calls attention to the question of inadequate capitalization being a situation which the Supreme Court stated was not before it in Kelley Co. v. Commissioner, 326 U.S. 521, 526; As material amounts of capital were invested in stock, we need not consider the effect of extreme situations such as nominal stock investments and an obviously excessive debt structure. and then points out that When at a later date this Court was confronted with the above situation, we held that the capital there paid in must be treated as stock rather than indebtedness. Swoby Corporation, 9 T. C. 887. Petitioner states that in the Dobkin case "the petitioners there made their loans at the inception of the corporation which loans remained constant and unchanged up to the time of liquidation of the corporation." Petitioner and his associates understood at *190 the inception of Est Company that they would advance the necessary funds for the company to acquire the property sought and on which to operate. There were instances when the equity of the property was purchased under contract so that the first advances did not cover the purchase price of the property. The record does not reveal the purchase price, the value of the property, the amount of the mortgages on the property, or for what purpose the subsequent advances were made to Est Company. As far as we can tell, such advances might have been made in pursuance of a purchase contract, and we are unable to conclude *487 that petitioner has established that he became a creditor of Est Company rather than an investor. He also contends that in Edward G. Janeway, 2 T. C. 197, affd. (C. A. 2) 147 F. 2d 602, referred to in the above quotation, the Court had under consideration an isolated transaction of the taxpayer while petitioner's activities were "extensive, varied, continuous and regular" for he had "made numerous loans to the Est Realty Corporation over an extended period of time commencing with November 30, 1930, and terminating on November 30, 1945." As we have pointed out, petitioner *191 has failed to show the purpose for which the advances were made, except that on the formation of a corporation it was undercapitalized, and the stockholders, under their agreement, immediately after formation of the company, were to advance the necessary funds for the acquisition of the property selected for the corporation to hold, and for its operation. We are not impressed with petitioner's contention that his activities were "extensive, varied, continuous and regular" with respect to making "loans" to corporations. Organizing corporations for the purpose of holding properties over a period of years may be "extensive," "continuous," and "regular" as to time and for investments. The record does not reveal the number of corporations that might have been in existence during any one year, but it is clear that there were many liquidations of corporations that had been organized and reinvestments of funds in new corporations. It was never the intention of petitioner and his associates to pay off the mortgages on the properties acquired -- "The mortgages were there when they bought them and they were there when they sold them except that they might have been reduced by amortization *192 payments by Est." The mortgages were usually two to five years of duration and the respective investments were seldom longer. Consequently, there was an "extensive," "continued," and "regular" investment and reinvestment in title-holding corporations, although the type of investment was not "varied." Furthermore, except for petitioner's financial interest in the respective corporations organized, there was no activity on his part with respect to the actual operations of the properties held. His activities were primarily with his accounting practice. After carefully considering all the facts before us, we reach the conclusion that the advances petitioner made to the Est Realty Corporation were contributions of capital, and sustain respondent on this issue. For cases in which the facts were otherwise, see Vincent C. Campbell, supra; and Weldon D. Smith, 17 T. C. 135. On the other issue, petitioner contends that the giving of his note and thus becoming primarily liable for his part of the Dune Realty *488 Corporation's mortgage which he, with his associates, had personally guaranteed, was a "constructive payment" of the corporate mortgage since the property of the company was released from *193 the lien, although he expressed his doubts on the question. As petitioner was on the cash receipts and disbursements basis and paid out nothing on his liability, he is not entitled in the taxable year 1945 to the deduction of $ 525, his share of the assumed liability. Helvering v. Price, 309 U.S. 409; Eckert v. Burnet, 283 U.S. 140. Respondent did not err in disallowing the deduction. Decision will be entered under Rule 50. Footnotes 1. SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: * * * * (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. This paragraph shall not apply in the case of a taxpayer, other than a bank, as defined in section 104, with respect to a debt evidenced by a security as defined in paragraph (3) of this subsection. This paragraph shall not apply in the case of a taxpayer, other than a corporation, with respect to a non-business debt, as defined in paragraph (4) of this subsection. * * * * (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 "nonbusiness 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.↩ 2. SEC. 117. CAPITAL GAINS AND LOSSES. (a) Definitions. -- As used in this chapter -- (1) Capital assets. -- The term "capital assets" means property held by the taxpayer (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or property, used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 23 (1), or an obligation of the United States or any of its possessions, or of a State or Territory, or any political subdivision thereof, or of the District of Columbia, issued on or after March 1, 1941, on a discount basis and payable without interest at a fixed maturity date not exceeding one year from the date of issue, or real property used in the trade or business of the taxpayer; * * * * (b) Percentage Taken into Account. -- In the case of a taxpayer, other than a corporation, only the following percentages of the gain or loss recognized upon the sale or exchange of a capital asset shall be taken into account in computing net capital gain, net capital loss, and net income: 100 per centum if the capital asset has been held for not more than 6 months; 50 per centum if the capital asset has been held for more than 6 months.