Drachman v. Commissioner

Richard M. Drachman, Petitioner, v. Commissioner of Internal Revenue, Respondent. Fanchon Drachman, Petitioner, v. Commissioner of Internal Revenue, Respondent. Eda Q. Drachman, Petitioner, v. Commissioner of Internal Revenue, Respondent Drachman v. Commissioner Docket Nos. 32975, 32976, 32977 United States Tax Court 23 T.C. 558; 1954 U.S. Tax Ct. LEXIS 10; December 30, 1954, Filed *10 Decisions will be entered under Rule 50. Petitioners owned 37 out of 345 shares of common stock of a corporation. At the beginning of 1948 the stock had some value. Petitioners were also members of a partnership which in order to protect its goodwill was forced in August 1948 to advance $ 10,000 to the corporation after it had become insolvent. The partnership was given the standing of a general creditor, and the creditors at that time hoped to recover the full amount of their claims. Stock was also issued to the members of the partnership in order that the creditors might obtain control of the corporation. By the end of 1948 the creditors knew that they could recover only a fraction of their claims, and there was no reasonable possibility that the stockholders would receive anything. Held, the $ 10,000 advanced to the corporation was a loan, rather than an expense or capital contribution, and the debt so created did not become worthless within the taxable year 1948. Held, further, the stock of the corporation acquired by petitioners prior to 1948 became worthless in the taxable year 1948 within the purview of section 23 (g) of the 1939 Code. Carl A. Stutsman, Jr., Esq., for the petitioners. George E. Constable, Esq., for the respondent. Bruce, Judge. BRUCE *558 Respondent determined deficiencies in petitioners' income taxes for the year 1948, as follows: Petitioner Deficiency Richard M. Drachman $ 847.65 Fanchon Drachman 876.09 Eda Q. Drachman 1,565.89 The proceedings were consolidated for hearing. Petitioners concede that some of the determinations made in the notices of deficiency are correct. The issues for decision are: (1) Whether $ 10,000 advanced by a partnership comprised of petitioners and one other, to Better Homes, Inc., in August 1948 constituted a loan, a business expense, or a capital contribution; and (2) Whether the stock of Better Homes, Inc., became worthless in the taxable year 1948. FINDINGS OF FACT. Petitioners are individuals residing*12 in Tucson, Arizona, and they filed their income tax returns for the calendar year 1948 with the collector *559 of internal revenue for the district of Arizona. Petitioners Richard M. Drachman and Fanchon Drachman are husband and wife and all of their income for the taxable year 1948 was community property. Petitioner Eda Q. Drachman is a widow and mother of Richard M. Drachman, who managed her business affairs. Drachman-Grant Realty Company (hereinafter referred to as the partnership) was a partnership engaged in the real estate and insurance business in Tucson, Arizona. Subsequent to April 1948, Richard M. Drachman owned as community property with his wife a 37 1/2 per cent interest in the partnership, Eda Q. Drachman owned a 37 1/2 per cent interest, and a third person, Edna Miller, held a life estate in the remaining 25 per cent interest. In 1945 certain employees of the partnership (not including any of the petitioners) formed a corporation known as Better Homes, Inc., to engage in the business of constructing residential buildings to be sold by the partnership. On December 31, 1947, the corporation had outstanding 345 shares of $ 100 par value common stock. Richard *13 M. and Fanchon Drachman held 10 shares and Eda Q. Drachman held 27 shares which they had purchased at par. Prior to August 1948 none of the petitioners was connected with the management of the corporation, and none of them had any knowledge of its financial affairs. Prior to August 1948, Better Homes, Inc., was managed by Burton Rysdale. The corporation was actively engaged in its business during the years 1946 and 1947, and at the beginning of 1948 it was a going concern. As of January 1, 1948, the corporation had a deficit of $ 30,820.37 and there existed a stockholders' equity of $ 3,679.63. By July 1948 the corporation's liabilities amounted to $ 249,653.66 against assets having a book value of $ 241,932.15, leaving no equity in the outstanding stock. The actual value of the assets was less than book value. During 1947 and the first half of 1948 Better Homes, Inc., became slower and slower in the payment of its debts. The principal creditors met together in July 1948 to discuss the condition of the corporation and the problems confronting them. The principal creditors were labor and material men who had possible liens against the houses which had been built by the corporation*14 and sold by the partnership. They did not wish to assert their liens, however, as it might have disrupted the building industry in Tucson. If possible, they wished to recover directly from the corporation. But the creditors did not wish to place the corporation in bankruptcy, as the corporation was in the process of constructing a number of houses. The creditors were of the opinion that they could recover closer to 100 *560 per cent of their claims if these houses were completed and there was an orderly liquidation of the assets. With the above plan in mind the creditors approached Richard M. Drachman in August 1948. As the creditors had advanced credit to Better Homes, Inc., on the strength of the reputation of the partnership, which appeared to be closely connected with the corporation, they felt that the partnership should aid them in realizing on their claims. They demanded that the partnership advance Better Homes, Inc., $ 10,000 to meet current operating expenses in order that the houses then under construction might be completed, and promised in return to forego their liens against the houses which the partnership had sold. In order to avoid a loss of goodwill and*15 reputation which would result from the filing of liens against the houses which the partnership had sold and the failure to deliver on the houses which were being built on a contract basis by Better Homes, Inc., the partnership advanced the $ 10,000 to the corporation on August 27, 1948. The advance was later charged to the capital accounts of the partners. The account of Richard M. and Fanchon Drachman was charged $ 3,800 and the account of Eda Q. Drachman was charged $ 3,700. At the time the $ 10,000 advance was made, Better Homes, Inc., owed the partnership $ 5,546.88 for sales commissions earned. It was understood between the other creditors and the partnership that the partnership would share, to the extent of $ 15,546.88, pro rata with the other creditors in any distribution. The creditors were of the opinion at that time that they might be able to recover the full amount of their claims. A day or so later, at the insistence of Edward W. Scruggs, the creditors' attorney, 100 shares of common stock were issued to the members of the partnership. The creditors were unwilling to go forward with the plan to complete the houses while Better Homes, Inc., was under the management*16 and control of Burton Rysdale. The stock was issued to the members of the partnership for the sole purpose of placing the control of the corporation in the hands of the creditors. Kermit C. Oestreich, one of the principal creditors, became the president of the corporation and remained the president until the houses were completed and the remaining assets of the corporation were transferred to a creditors' trustee on June 15, 1949. Edward W. Scruggs, Richard M. Drachman, and several other creditors became directors of the corporation. On monthly statements prepared by an accountant hired by Better Homes, Inc., the $ 10,000 which was advanced by the partnership was treated as a capital contribution. *561 By December 31, 1948, the deficit of Better Homes, Inc., had increased. The creditors knew by that time that they would be able to realize only a fraction of their claims. The stock of the corporation was absolutely worthless, and petitioners have not received anything for their stock. On June 15, 1949, an agreement was entered into between Better Homes, Inc., the creditors' trustee, and the creditors. Under the agreement all of the remaining assets of the corporation were*17 transferred to the creditors' trustee in discharge of the corporation's indebtedness. In the agreement the partnership was recognized as a creditor to the extent of $ 15,546.88. In 1949, 1950, and 1951, petitioners received their pro rata portion of the payments made by the creditors' trustee to the partnership on its $ 15,546.88 claim. The final distribution was made in 1951. The total amount received by the creditors represented only a small percentage of their claims. On their income tax returns for the year 1948 Richard M. and Fanchon Drachman treated their 48 shares of Better Homes, Inc., common stock as worthless and claimed a short-term capital loss of $ 4,800. Eda Q. Drachman treated her 64 shares as worthless and claimed a long-term capital loss of $ 6,400. Respondent disallowed any deduction for the Better Homes, Inc., stock on the ground that the stock did not become worthless during the year 1948. OPINION. Prior to 1948 petitioners were the owners of 37 out of 345 shares of common stock of a corporation known as Better Homes, Inc. They were also members of a partnership which in order to protect its goodwill was forced in August 1948 to advance $ 10,000 to the corporation*18 after it had become insolvent. The partnership was given the standing of a general creditor, and at that time the creditors hoped to recover the full amount of their claims. For the sole purpose of placing the creditors in control of the corporation, the members of the partnership received in 1948 100 shares of common stock without further payment, of which 75 shares were issued to petitioners. By the end of 1948 the creditors knew that they could recover only a fraction of their claims. The principal question is whether the $ 10,000 which was advanced by the partnership to the corporation in August 1948 represented an expense, a capital contribution, or a loan. The advance had some of the characteristics of each. It was made in the form of a capital contribution in that the members of the partnership received common stock having an aggregate par value equal to the amount of the advance. It had the characteristics of an expense because the partnership *562 made the advance for the sole purpose of protecting its reputation and goodwill. And it had the attributes of a loan because the partnership was given the standing of, and was treated as, a general creditor with respect*19 to the advance. Petitioners contend that the advance was a deductible expense within the purview of section 23 (a) (1) (A) of the 1939 Code. 1 We might agree with the petitioners if the partnership had not been given the standing of a general creditor and the right to reimbursement. In Glendinning, McLeisch & Co., 24 B. T. A. 518, 523, affd. (C. A. 2) 61 F. 2d 950, it was stated: It is well settled by decisions of this Board that, where the taxpayer makes expenditures under an agreement that he will be reimbursed therefor, such expenditures are in the nature of loans or advancements and are not deductible as business expenses. George M. Cohan, 11 B. T. A. 743, affirmed on this point, 39 Fed. (2d) 540; H. R. McMillan, 14 B. T. A. 1367; Henry F. Cochrane, 23 B. T. A. 202. *20 In Dunn & McCarthy, Inc. v. Commissioner, (C. A. 2) 139 F. 2d 242; Robert Gaylord, Inc., 41 B. T. A. 1119; Edward J. Miller, 37 B. T. A. 830; First National Bank of Skowhegan, 35 B. T. A. 876, and C. H. White, 15 B. T. A. 1375, cited by petitioners, and in Ray Crowder, 19 T. C. 329, and E. P. Adler, 44 B. T. A. 112, the taxpayer, at the time the advancement was made, either did not expect reimbursement or had no hope of being reimbursed more than a small percentage of the amount of the advancement. Here the other creditors, at the time the money was advanced by the partnership, were hopeful that they would be able to recover the full amount of their claims. Petitioners, who have the burden of proving that the advance was an expense and not a loan, have not shown that they were more pessimistic than the other creditors. Cf. George B. Markle, Jr., 17 T. C. 1593, appeal dismissed (C. A. 3, 1953). For the advance to be a loan, it is *21 not necessary that there be an unqualified expectation of repayment. Cf. Franklin Q. Brown et al., 9 B. T. A. 965; Stange-Elliott Coal Co., 4 B. T. A. 745. See also Dallas Rupe & Son, 20 T. C. 363; McKay Products Corporation, 9 T. C. 1082, affirmed on this point (C. A. 3), 178 F. 2d 639, certiorari dismissed 339 U.S. 961; Standard Oil Co. of New Jersey, 7 T. C. 1310, appeal dismissed (C. A. 2); Thomas J. Avery, 11 B. T. A. 958. Respondent contends that the advance was a capital contribution. Whether it was a capital contribution or loan is a question of fact. *563 Sam Schnitzer, 13 T. C. 43, affd. (C. A. 9) 183 F. 2d 70, certiorari denied 340 U.S. 911. The form of the transaction is not controlling, for, as the Supreme Court pointed out in John Kelley Co. v. Commissioner, 326 U.S. 521, "So-called stock certificates may be*22 authorized by corporations which are really debts, and promises to pay may be executed which have the incidents of stock." After considering all of the facts, we are of the opinion that the instant transaction was a loan rather than a capital contribution. The stock was issued to the members of the partnership at the insistence of the attorney for the other creditors for the sole purpose of allowing the creditors to obtain control of the corporation. The stock had little or no value and was issued after the partnership had established its position as a general creditor. The partnership could expect reimbursement only as a general creditor and not as a stockholder. This Court was presented with a similar situation in Grant G. Simmons, 4 T. C. 478. There the taxpayer advanced $ 10,000 to a corporation. The taxpayer became an unsecured creditor in that amount and also received 390 shares of stock without further payment. We found that the stock was received in lieu of interest and to give the taxpayer and others making similar advances an interest in and control of the corporation in order to make the repayment of the loans more likely. We held that*23 the full amount of the advance was a loan. As the debt created by the advance to the corporation did not become worthless within the taxable year 1948, petitioners are not entitled to a business bad debt deduction for that year under section 23 (k) (1) of the 1939 Code. 2 Cf. Loewi & Co., 23 T. C. 486. See also Stuart Bart, 21 T. C. 880. But as petitioners have protected themselves by deducting the unrecovered balance in their 1951 individual income tax returns, no undue hardship should result. The remaining issue for decision is whether petitioners are entitled to a worthless stock deduction under section 23 (g) of the 1939 Code, 3*564 with respect to the 37 shares of Better Homes, Inc., common stock which they acquired prior to 1948. *24 The question is one of fact. M. Rea Gano, 19 B. T. A. 518. We have found that the corporation was a going concern and that the stockholders had some equity and their stock some value at the beginning of 1948. During the year 1948 the corporation became insolvent and the creditors assumed control of the corporation. The creditors planned to complete the houses then under construction and to liquidate the remaining assets of the corporation in order to satisfy their claims. At the end of 1948 the creditors knew that they could recover only a fraction of their claims, and there was no reasonable possibility that the stockholders would realize anything on their shares. On June 15, 1949, the remaining assets, amounting to only a fraction of the creditors' claims, were transferred to a creditors' trustee in discharge of the corporation's indebtedness. These facts establish that the stock became worthless in the year 1948 within the meaning of section 23 (g), and petitioners are entitled to deduct the cost of their original 37 shares as a long-term capital loss. Cf. J. Harvey Ladew, 22 B. T. A. 443; C. E. Conover Co., 7 B. T. A. 1234.*25 Decisions will be entered under Rule 50. Footnotes 1. SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: (a) Expenses. -- (1) Trade or business expenses. -- (A) In General. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, * * * ↩ 2. 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; * * *↩ 3. SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: * * * * (g) Capital Losses. -- * * * * (2) Securities becoming worthless. -- If any securities (as defined in paragraph (3) of this subsection) become worthless during the taxable year and are capital assets, the loss resulting therefrom shall, for the purposes of this chapter, be considered as a loss from the sale or exchange, on the last day of such taxable year, of capital assets. (3) Definition of securities. -- As used in this paragraph (2) of subsection the term "securities" means (A) shares of stock in a corporation, and (B) rights to subscribe for or to receive such shares.↩