Brenhouse v. Commissioner

S. E. Maitland Brenhouse, Petitioner, v. Commissioner of Internal Revenue, Respondent Brenhouse v. Commissioner Docket No. 74134 United States Tax Court 1961 U.S. Tax Ct. LEXIS 28; 37 T.C. 326; November 24, 1961, Filed *28 Decision will be entered under Rule 50. Advances to unrelated corporation from which petitioner's partnership anticipated assistance in carrying on of partnership's business, and which turned out to be worthless, held deductible as business bad debts. I. Frederick Shotkin, Esq., for the petitioner. Joseph Wilkes, Esq., for the respondent. Opper, Judge. OPPER *326 Respondent determined a deficiency in petitioner's income tax of $ 11,816.48 for the year 1947 by disallowing a bad debt deduction claimed in 1949 and effective for 1947 because of a net operating loss deduction. The issues are: (1) Whether the advances by petitioner were loans or capital contributions; (2) if they were loans, whether petitioner proved that they became worthless in 1949; and, if so, (3) whether they are "business" or "non-business" debts within the meaning of section 23(k)(4) of the 1939 Code. FINDINGS OF FACT. The stipulated facts are hereby found accordingly. S. E. Maitland Brenhouse, hereinafter called petitioner, is an individual residing in Hastings-on-Hudson, New York. Petitioner's return for the period here involved was filed with the district director of internal revenue, *29 Upper Manhattan District, New York. Petitioner was on the cash basis of accounting during the calendar year 1949. During the summer of 1948, petitioner and Martin Kornbluth formed a partnership under the firm name of Martland. The business *327 of the partnership was the design and sale of point-of-sale displays. These are metal, wood, or wire devices which are used to display and exhibit merchandise to customers. Kornbluth became the sales manager of the business and it was his responsibility to promote the product of the company. Petitioner was to supply all necessary capital. The two partners were to share profits equally; Kornbluth would receive no salary and petitioner would bear all the losses. The partnership retained a staff of five or six salesmen, each of whom had a drawing account and worked on 10 percent commission. The partnership could not recover from the salesmen for drawings in excess of commissions. Towards the end of 1948, petitioner thought that the salesmen were not producing enough business to support the drawings. Petitioner attempted to make some connection with an existing display outfit, a firm actually selling permanent point-of-sale displays*30 to national concerns, and utilize this connection as entree to national buyers. Petitioner was informed by a business broker about Peter Junco Studios, Inc., hereinafter called Studios, an industrial photography company with connections with large advertising agencies and national manufacturers who would be customers for point-of-sale displays. In December 1948, Peter Junco, hereinafter called Junco, telephoned petitioner and tried to arrange a meeting. They discussed an arrangement by which, in return for advances from petitioner, Junco was to introduce petitioner to display buyers. The salesmen of Studios would work for Martland on a commission half that of Martland's commission to its regular salesmen, i.e., 5 percent instead of 10 percent. Several attempts were made to arrange a personal meeting between Junco and petitioner in January. After many telephone calls, Junco asked petitioner for an advance if they could not meet. On January 26, 1949, petitioner was forced to cancel an appointment with Junco but sent $ 5,000 as a loan to Studios by means of petitioner's attorney. Petitioner received a 60-day $ 5,000 non-interest-bearing note from Studios endorsed by Junco and his*31 wife. Studios also gave petitioner a chattel mortgage on its equipment. Petitioner requested his accountant, hereinafter called Lasser, to have someone investigate Studios. An accountant checked the physical plant, the volume of the business, and the nature of the accounts of Studios and returned with a favorable report. Early in February petitioner had his first meeting with Junco. On March 22, 1949, another $ 5,000 was advanced by petitioner to Studios. This was to be a short-term loan and no security was received. On March 27, the first note came due and petitioner made a demand for payment. Junco told petitioner that the entire amount, $ 10,000, would be repaid shortly. *328 Petitioner was becoming concerned about the size of the debt. He then asked Junco to introduce him to Jack Hocking, advertising manager in charge of footwear and other products of U.S. Rubber Company and hereinafter referred to as Hocking. Hocking was an important point-of-sale buyer whom Martland had not been able to contact independently. Late in March Junco arranged a meeting with Hocking, who expressed interest in Martland's business. Shortly thereafter, Hocking left town and petitioner started*32 advancing some money to Studios every few weeks. On April 11, petitioner advanced $ 1,000; on April 12, $ 2,500; on April 18, $ 2,600. On April 22, petitioner called Junco to his office to formalize all the advances. Studios gave petitioner a $ 15,100 non-interest-bearing demand note, endorsed by Junco and his wife, and an additional chattel mortgage. A day or two later petitioner's attorney discovered prior chattel mortgages on the Studios property. Junco alleged that these mortgages had been reduced and promised to pay petitioner as soon as Studios finished a picture for U.S. Rubber. Petitioner then requested a meeting with Junco and his attorney. On April 26 or April 27, Lasser examined the books of Studios and reported a serious financial situation to petitioner. Petitioner then asked Junco for a formal statement and Junco promised one in a few days. On April 26 petitioner advanced an additional $ 3,000 directly to Studios' landlord. Petitioner was asked to advance this to allow Studios to finish its picture and permit petitioner to be paid. At the same time, petitioner advanced an additional $ 2,500 to Studios on the promise of a statement. Petitioner received a $ 5,500*33 non-interest-bearing demand note from Studios, endorsed by Junco's wife, and a further chattel mortgage. Immediately thereafter, on April 28 or 29, petitioner finally received an informal balance sheet prepared from Studios' "working papers," which disclosed Studios' insolvency. Early in May 1949, petitioner foreclosed on his chattel mortgages. At the foreclosure sale, which was attended by the prior mortgagees, petitioner bid in the chattels for $ 1,000, subject to the rights of the prior mortgagees. There was approximately $ 23,000 in prior mortgages outstanding. These were eventually paid off. The $ 1,000 bid by petitioner was used to pay the expenses of the foreclosure sale and petitioner received nothing toward the obligation owed to him by Studios. Petitioner never received any repayment of the $ 25,600 advanced to Studios from Studios, Junco, or his wife. An involuntary petition in bankruptcy was filed against Studios in the United States District Court for the Southern District of New *329 York on July 22, 1949, and Studios was adjudicated a bankrupt on August 8, 1949. Petitioner did not receive anything from this bankruptcy proceeding. Petitioner made no attempt*34 to collect the amount owed him by Studios from Junco or his wife. The Juncos owed a substantial amount to the United States Government and to the city collector of New York City which would not be discharged by personal bankruptcy and there was no possibility of petitioner receiving any payment. Petitioner organized a commercial photography and movie studio called Seaboard Studios, in connection with which he used Studios' equipment. Petitioner is currently treasurer of and owns a one-third stock interest in a corporation called Commercial Studios which does photographic artwork from models for mail-order catalogs. Petitioner's partnership made sales of its displays to U.S. Rubber by reason of his being introduced to Hocking. The amounts of the sales were in excess of $ 5,000 and $ 17,000 for the years 1949 and 1950, respectively. In the latter part of 1948, Sanford Johnson applied for employment with Martland but was not hired. In April 1949, Sanford Johnson was employed by Studios on the recommendation of petitioner. Martland made sales to National Distillers, Eastman Kodak, and Recordak. This business was solicited for Martland by Johnson, as well as by Fairchild Fleming, an*35 employee of Martland. The total sales of Martland in 1949 amounted to $ 147,410.95. The total sales of Martland in 1950 exceeded $ 430,000. The advances by petitioner to Studios were business debts, made with the expectation of repayment, that became worthless and were charged off in the year 1949. OPINION. We are unable to follow respondent's contention that petitioner failed to show that any debt owing to him by Studios became worthless in 1949. The inadequacy of any available assets to satisfy the obligation is inescapable and no prior year is involved since the transactions did not occur until 1949. The proposition is, in fact, inconsistent with another contention by respondent that the debts were worthless when acquired and cannot accordingly be allowed as a deduction. This is a factor that requires more serious consideration. It is indeed difficult to understand how such considerable sums were risked with so little investigation, and, as ultimately developed, so small a prospect of recovery. But -- it is not our province to inquire into the wisdom of the loan; it is only necessary for the petitioner to establish the fact that the amounts advanced were ascertained *330 *36 to be worthless and charged off within the taxable year. [.] And this is not an instance where any other explanation than a bona fide business transaction is available. Cf. . Petitioner had no financial interest in the corporation which obtained the funds, nor in its individual stockholders. Cf. ; . Nor was there any other personal relationship which would explain the advances. Cf. . Respondent's further contention appears to us again to be inconsistent with what has just been said. Any conclusion that the petitioner was making a capital investment in a worthless enterprise is less believable than that he should lend it money, since at least the latter arrangement gave him some position of priority. Finally, if this was a debt, as we have determined that it was, it could not have been a nonbusiness bad debt. The only reason for its existence*37 was a proximate, although perhaps overoptimistic, relation to the business of petitioner's partnership and its worthlessness was the direct consequence of that situation. 1; Robert Cluett, 3rd, ; ; . *38 And it cannot be said here, as in cases involving incorporated enterprises, that the business of the corporation is not that of the stockholder. Cf., e.g., (C.A. 2, 1957), affirming a Memorandum Opinion of this Court. Petitioner, as the member of a partnership, was directly subject to tax on any business profits, sec. 181, 1939 Code, including those which the record here shows flowed directly from the contacts created by the advances. See , affd. (C.A. 9, 1955). Under all the circumstances, we see no escape from the conclusion that these were bona fide debts, that they became worthless in 1949, and that they were deductible, and available for carryback, as business bad debts. To take account of a slight difference between the amount originally disallowed and that now stipulated to have been advanced, Decision will be entered under Rule 50. Footnotes 1. Sec. 29.23(k)-6, Regs. 111. 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 purpose of this amendment.↩