Gable v. Commissioner

Frank H. Gable and Wilma Fay Gable, Petitioners, v. Commissioner of Internal Revenue, Respondent Gable v. Commissioner Docket No. 77749 United States Tax Court 34 T.C. 228; 1960 U.S. Tax Ct. LEXIS 152; May 19, 1960, Filed *152 Decision will be entered for the respondent. Held: Petitioner Frank H. Gable's notes aggregating $ 36,250 against the Toff Corporation which he received from time to time in 1953 and 1954 as he made advancements to Toff under an agreement designated as "Loan Agreement" did not represent debts against Toff. These advancements which petitioner made to Toff represented capital investments in Toff and were the cost of the 208 shares of Toff common stock which petitioner received from the two stockholders of Toff from time to time as he made the advancements to Toff in compliance with the so-called loan agreement which petitioner made with Toff and its two sole stockholders prior to the advancements. Held, further, petitioner's stock in Toff thus acquired was not worthless on December 31, 1955. The Commissioner's determination is sustained. Philip I. Palmer, Esq., for the petitioners. Edward John Eagleton, Esq., and Allen T. Akin, Esq., for the respondent. Black, Judge. BLACK *228 The Commissioner has determined a deficiency in petitioners' income tax for the year 1955 of $ 14,644.71. The deficiency is due to two adjustments made by the Commissioner to the income reported by petitioners on their return. The adjustments are: (a) Bad debt $ 36,250 (b) Contributions disallowed [490] The only adjustment in issue is adjustment (a). It is explained in the deficiency notice as follows: *229 (a) It is determined that the deduction claimed as a business bad debt loss in amount of $ 36,250.00 for alleged advances to Toff Corporation is unallowable under existing internal revenue laws. Petitioners, by appropriate assignment of error, contest the foregoing adjustment. FINDINGS OF FACT. Some of the facts have been stipulated and are incorporated herein by this reference. Petitioners are husband and wife and reside in Dallas, *154 Texas. They filed a joint income tax return for the calendar year 1955 with the district director of internal revenue at Dallas. Petitioner Frank H. Gable, sometimes hereafter referred to as petitioner, was engaged in business during 1955, as a sole proprietor, primarily as an electrical engineer and contractor. In January 1950, the Toff Corporation, sometimes hereafter referred to as Toff, a Texas corporation, entered into a contract with R. L. Biesele, Jr., for the development of an electrical device to ascertain mechanically the grade and staple of cotton. In May 1953, Toff and its two stockholders, William D. Felder, Jr., and Edward H. Tenison, entered into an agreement with petitioner designated as a "Loan Agreement" under the terms of which petitioner was to advance sums from time to time to Toff for its promissory notes for the financing of further development of the cotton classer. This loan agreement contained, among other things, the following provisions: F. H. Gable will from time to time advance cash to the corporation and take therefor the usual 5% demand notes of the corporation and, additionally as each cash advance is made he will become entitled to receive from*155 W. D. Felder, Jr. and Edward H. Tenison (in the proportions of 80% from W. D. Felder, Jr. and 20% from Edward H. Tenison) a fractional portion of the 500 shares of the capital stock of the Toff Corporation. Said fraction shall be ascertained from time to time as each advancement is made; the numerator of such fraction being the total number of dollars advanced by Gable to Toff Corporation as of the date of such given advancement and the denominator of such fraction being 33,000 plus the total amount of cash advanced by Gable hereunder. That is to say for example if on May 10, 1953, Gable advances (as his first advancement) to Toff Corporation the sum of $ 2,500.00 then Gable will be entitled to receive from Felder and Tenison (in the proportions stated) an aggregate of 2500 / 35,500 X 500 shares of Toff Corporation capital stock; and if, continuing the example, on June 10, 1953, Gable advances (as his second advancement) to Toff Corporation the sum of $ 3,000.00 then and at that time Gable will be entitled to receive from Felder and Tenison a total amount of stock (including the previous issue or issues) 2500+3000 / 33,000 + 2500+3000 x 500 shares = 5500 / 38,500 x 500 = 71.4 *156 shares *230 Gable will advance monthly funds as needed until his total investment is $ 33,000.00 which will exactly match out of pocket expense of Felder and Tenison. At that time under the above formula Gable will have been issued 33,000 / 33,000 + 33,000 x 500 = 250 shares From May 1953 through December 1954, petitioner advanced $ 36,250. At the time of the advancement of these sums by petitioner, he was to receive from Felder and Tenison, shareholders of Toff, assignments of shares of the capital stock of Toff under a formula which determined the amount of the assignments in accordance with the amount advanced. During the period petitioner made such advancements he received assignments from Felder and Tenison of 208 shares. On the following dates petitioner advanced to Toff the various sums of money set forth opposite the respective dates, receiving therefor notes duly executed by Toff, payable to petitioner on demand, for the various sums of money set opposite the respective dates, at 5 per cent interest from date, the notes totaling in all $ 36,250: May 4, 1953 $ 2,500 June 13, 1953 2,000 July 9, 1953 2,500 Aug. 17, 1953 1,500 Sept. 8, 1953 2,000 Oct. 1, 1953 2,000 Nov. 10, 1953 2,000 Dec. 3, 1953 2,000 Jan. 12, 1954 2,000 Feb. 17, 1954 2,000 Mar. 31, 1954 2,000 Apr. 30, 1954 2,000 June 1, 1954 2,000 July 1, 1954 2,000 July 13, 1954 1,000 July 31, 1954 2,000 Aug. 30, 1954 1,500 Sept. 16, 1954 1,250 Nov. 8, 1954 1,250 Dec. 4, 1954 [750] Total 36,250 *157 On January 31, 1955, Toff, Felder, Biesele, and petitioner entered into a contract with United States Testing Company, Inc., sometimes hereafter referred to as Testing Company, for the further development of the cotton classer. On May 4, 1955, Testing Company advised Toff that the cotton classer would class cotton when operated by an engineer familiar with the machine and with various qualities of cottons so that the principles of the instrument were validated. Testing Company was convinced that the cotton could be classed by an instrument similar to the Toff device that they had been working on, but many changes were anticipated before the services of such a device would be commercially marketable. In closing, the company representative in a letter stated: To put large additional sums of money and time on this device, to us, does not seem to be practical. Much has been learned from the previous work done by Biesele and from the few months we have had the device here for study in *231 our laboratories. We are convinced that cotton can be classed on an instrument embodying the principles of the present machine, but with different conceptions as to how the various qualities*158 that go into classing cotton should be obtained from an instrument. We would like to have your reactions to the data that we are forwarding on the first series of tests made on the machine, and are looking forward to your visit on May 17. On June 10, 1955, Testing Company wrote a letter to Biesele for Toff stating that while they were interested in the cotton classer, they wished to study the matter further. They then anticipated an additional expenditure of $ 50,000 for the new machine would be necessary. On July 6, 1955, they wrote that while interested, they were doubtful about a tie-in with Toff because of its obligations and in this letter they suggested a possible formation of a new company, eliminating the note obligations of Toff. On August 30, 1955, Testing Company advised Toff that it did not wish to extend the original agreement and declined its option for stock, demanded payment of $ 19,150.65, and asked for shipping instructions for the cotton classer. On December 5, 1955, Testing Company proposed continuing work on a cotton classer on the basis that Toff assign all its rights in the machine to Testing Company and receive 7 1/2 per cent of any income received by Testing*159 Company from licensing the machine. This offer was not accepted and Toff ordered the machine as it existed shipped back to Dallas. Testing Company refused to proceed with the development of the electronic cotton classer unless the note obligations of Toff were subordinated to its indebtedness incurred and to further advances to be made. After Testing Company refused to proceed with the development of the electronic cotton classer under the agreement of January 31, 1955, that particular machine was abandoned. This was the situation at the close of 1955. At the close of 1955, Toff had assets consisting of tools and fixtures having a fair market value of $ 1,000. It still owned its patent rights to the cotton-classing machine but these patent rights had very little, if any, fair market value on December 31, 1955. In January 1956, Testing Company reopened negotiations with Toff, Felder, and petitioner resulting in the formation of a new corporation, DSP, in April of 1956. Its shareholders were as follows: Class A, Testing Company, 200 shares; class B, petitioner, 400 shares; Felder, 320 shares; and Biesele, 80 shares. These shares had a par value of $ 1 a share and the subscribers*160 paid in $ 2 per share in cash. DSP acquired the assets of Toff for $ 1,000, including all rights to the cotton classer in April 1956. The Toff stock, aggregating 240 shares, held by Felder and Biesele was purchased by petitioner in April 1956 at a price of $ 4.40 per *232 share, and all the notes of Toff held by Felder and Biesele were thrown in gratis with the stock. Toff's name was changed in April 1956 to Gable Electric Service, Inc., and became petitioner's operating corporation. In 1958, the notes of Toff were capitalized on the books of Gable Electric Service, Inc. Petitioner had been engaged in the development of electronic devices since 1932. He had developed an electronic pressure volume indicator, a long-playing wire reproducer, he had done work on the electronic cotton classer, square waves generator, a timer for aircrafts, and numerous other devices, advancing funds, labor, material, and ideas. Some of these electronic devices on which petitioner worked were successful and some were not successful. The primary activity of petitioner's business was electrical contracting and it was from this activity that the principal part of his income was derived. In their joint*161 income tax return for 1955 petitioners deducted under the heading of expenses, among other things: "Bad Debt Loss on Toff Corporation $ 36,250.00." The Commissioner disallowed this deduction. The advances by petitioner to Toff in the years 1953 and 1954, which were evidenced by promissory notes, represented risk capital by petitioner in Toff, rather than loans by petitioner to Toff. Petitioner's stock in Toff was not worthless at December 31, 1955. OPINION. Petitioners in their brief contest the correctness of the determination of the Commissioner on four grounds. These grounds are stated in their brief as follows: 1. The money advanced by taxpayers to the Toff Corporation for which said corporation gave its notes, was not a contribution to the capital of said corporation. 2. The notes of Toff Corporation held by taxpayers were valid obligations of said corporation at the beginning of the year 1955 and by reason of the then development of the cotton classer appeared reasonably certain to be paid. 3. The notes of Toff Corporation held by taxpayers were worthless at the end of 1955. 4. The bad debt [loss] suffered by taxpayers by reason of the worthlessness of the Toff Corporation*162 notes held by them December 31, 1955, was a business debt. Petitioners' grounds 1 and 2 must be considered together because they are necessarily linked together. After a careful consideration of all the evidence in the record, both oral and documentary, we hold that petitioner's advancements to Toff were capital contributions to Toff, rather than loans. We think this fact is evidenced by the loan agreement itself. The loan agreement is quite lengthy and it does not seem practical to quote all of it in our Findings of Fact. It is, *233 of course, incorporated in its entirety by reference because it is one of the exhibits attached to the stipulation of facts. We have quoted a part of it which we think proves that petitioner's advancements were intended as investments rather than loans. The two stockholders, Felder and Tenison, had made advancements in proportion to their stock ownership in Toff but they had reached the point where they were unwilling to make further advancements. It was then that the loan agreement was entered into and the provisions of this agreement make clear that petitioner was making sure that by reason of the advancements to Toff which he agreed to*163 make he would own the same proportional interest in Toff as Felder and Tenison, who had together advanced to Toff the aggregate sum of $ 33,000. This latter amount was the sum which petitioner agreed to advance to Toff. It is true that in the end he advanced $ 36,250 instead of $ 33,000 as he had agreed in the loan agreement. We do not think, however, that this difference changes the character of his advancements. That his advancements to Toff were risk capital rather than loans we think is evidenced by the language in the agreement which says: Gable will advance monthly funds as needed until his total investment is $ 33,000.00 which will exactly match out of pocket expense of Felder and Tenison. At that time under the above formula Gable will have been issued 33,000 / 33,000 + 33,000 x 500 = 250 shares [Emphasis supplied.] It is true that petitioner was given promissory notes payable on demand and drawing interest at the rate of 5 per cent per annum. It is also true that Felder and Tenison were given notes of the same character for their advancements. But notwithstanding that petitioner received promissory notes for his advancements as did Felder and Tenison, we do*164 not think that fact changes the character of his advancements. We still think they represented risk capital invested in Toff rather than loans. In Sam Schnitzer, 13 T.C. 43, affirmed per curiam 183 F. 2d 70 (C.A. 9), certiorari denied 340 U.S. 911, we said: This question is one of fact. Cohen v. Commissioner, supra [148 F. 2d 336 (C.A. 2)]. And in deciding whether or not a debtor-creditor relation resulted from advances, the parties' true intent is relevant, Fairbanks, Morse & Co. v. Harrison (N.D. Ill.), 63 Fed. Supp. 495; Edward Katzinger Co., supra [44 B.T.A. 533, affd. 129 F. 2d 74 (C.A. 7)]; Daniel Gimbel, 36 B.T.A. 539. Bookkeeping, form, and the parties' expressions of intent or character, the expectation of repayment, the relation of advances to stockholdings, and the adequacy of the corporate capital previously invested are among circumstances properly to be considered, for the parties' formal designations of the advances are not conclusive, United Statesv. South Georgia Ry. *165 Co., supra [107 F. 2d 3 (C.A. 5)], *234 but must yield to "facts which even indirectly may give rise to inferences contradicting" them. Cohen v. Commissioner, supra. * * * As the Supreme Court said, however, in Talbot Mills [John Kelley Co.] v. Commissioner, supra [326 U.S. 521]: "* * * There is no one characteristic * * * which can be said to be decisive in the determination of whether the obligations are risk investments in the corporations or debts. * * *" Section 165, I.R.C. 1954, dealing with losses reads in part as follows: SEC. 165. LOSSES. (a) General Rule. -- There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise. * * * * (g) Worthless Securities. -- (1) General rule. -- If any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall, for purposes of this subtitle, be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset. (2) Security defined. -- For purposes of this subsection, the term "security" means -- (A) a share of stock in a corporation; On December*166 31, 1955, petitioner owned 208 shares of Toff common stock which, as we view it, had cost him $ 36,250, the total amount of his advancements to Toff. While it is clear that petitioner's stock in Toff did not have much value on December 31, 1955, it did have some value at that time. In April 1956, petitioner purchased Felder's and Tenison's stock in Toff for $ 4.40 per share and Felder and Tenison transferred to petitioner their notes against Toff without any additional payment. This certainly indicates that the Toff shares of stock were not worthless on December 31, 1955. When, if ever, petitioner's stock in Toff became worthless, we do not decide. What we do decide is that petitioner's stock in Toff did not become worthless in 1955. As to petitioner's contention No. 3 above stated, it is disposed of by our decision that petitioner's notes in Toff represented capital invested in Toff and did not become worthless in 1955. As to petitioner's contention No. 4 stated above, it would only become pertinent if we should hold that petitioner's notes represented debts against Toff and were therefore covered by section 166 of the 1954 Code. Having held that these notes represented a capital*167 investment by petitioner in Toff and were not debts against Toff, section 166 has no application and we hold against petitioner's contention that it does have application. Decision will be entered for the respondent.