Adler v. Commissioner

E. P. ADLER, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Adler v. Commissioner Docket No. 97988. United States Board of Tax Appeals 44 B.T.A. 112; 1941 BTA LEXIS 1388; April 8, 1941, Promulgated *1388 The petitioner was president of and a stockholder in a corporation which at the end of 1932 owed to a bank certain indebtedness represented by promissory notes on which the petitioner was an endorser and in connection with which he had pledged certain personally owned assets as collateral. The corporation operated at a loss throughout its existence and by 1932 its capital had been fully exhausted. In the early part of 1933, when several of the notes had become due but remained unpaid and the balance of the notes were to become due within a few weeks, a representative of the bank, after having ascertained that the corporation was insolvent but that the petitioner was solvent, approached the petitioner with respect to making payment of the notes. In order to avoid having to make present payment of his liability as endorser on the notes and in order to reduce if possible the amount he would eventually have to pay on them, the petitioner entered into an agreement with the bank's representative whereby the time of payment was extended for four years in consideration of the petitioner's guaranteeing that a certain contemplated four-year lease of the corporation's property, which was*1389 to be assigned to the bank, would be kept in full force and effect throughout the life thereof and that the corporation would not default in the performance of its covenants thereunder. Pursuant to the agreement the petitioner, during the years 1935, 1936, and 1937, made payment of certain of the corporation's operating expenses to enable it to carry out the terms of the lease, knowing, however, that the corporation was not and would not be able to make repayment to him. held, that the amounts so paid represented losses sustained by the petitioner in the respective years and were deductible as such in the years in which paid. Edward S. Bentley, Esq., and Clifford Yewdall, C.P.A., for the petitioner. Angus R. Shannon, Esq., for the respondent. TURNER *113 The Commissioner determined a deficiency of $3,983.52 in the petitioner's income tax for 1936 and a deficiency of $317.02 in his income tax for 1937. The only issues involved are whether the petitioner is entitled to a deduction of $11,554.09 taken in 1936 and $657.50 taken in 1937 representing expenditures made in connection with the operation of the Davenport Airways, Inc., a corporation*1390 on whose notes he was liable as an endorser. FINDINGS OF FACT. The petitioner is an individual whose place of business is at Davenport, Iowa. His Federal income tax returns for 1936 and 1937 were duly filed with the collector of internal revenue at Des Moines, Iowa. During August 1929 the petitioner caused to be formed under the laws of Iowa a corporation known as Davenport Airways, Inc., sometimes hereinafter referred to as Airways, with an authorized capital stock of $100,000 divided into 1,000 shares of $100 each. Airways was organized to take over and operate an airport at Davenport, Iowa, then owned and operated by L. M. Pedigo. Of its authorized capital stock the corporation issued 554 shares, certificate No. 1 for 10 shares being issued to the petitioner. Of the remaining shares that were issued, 250 were issued to Pedigo for the Airport. The petitioner subsequently acquired an interest in the 250 shares issued to Pedigo. The petitioner became president of Airways in 1929 and continued to act in that *114 capacity until the corporation was dissolved in 1937, during which year the liquidation of its business and affairs was completed. On August 9, 1929, Airways*1391 entered into a written contract with the city of Davenport whereby Airways leased its airport to the city for the period of four years at an annual rental of $5,000. By reason of the installation of certain additional equipment at the airport, a supplemental agreement in writing was entered into on April 3, 1930, between Airways and the city whereby the annual rental to be paid by the city was increased to $8,208.33. Due ot the depression which followed shortly after the organization of Airways, it operated at a loss from the time of its formation until it was liquidated. By 1932 its capital had been fully exhausted. Prior to December 24, 1932, Airways had borrowed $26,278.51 from the Union Savings Bank & Trust Co. of Davenport, sometimes hereinafter referred to as the bank, which amount on that date was represented by eleven promissory notes described as follows: No. Date Date due Amount 95377 July 5, 1932 Jan. 5, 1933 $778.51 95552 July 9, 1932 Jan. 9, 1933 500.00 96449 July 20, 1932 Jan. 20, 1933 500.00 96704 Sept. 9, 1932 Mar. 9, 1933 1,200.00 96879 Sept. 16, 1932 Mar. 17, 1933 800.00 97057 Sept. 24, 1932 Dec. 27, 1932 5,000.00 97520 Oct. 15, 1932 Jan. 16, 1933 1,500.00 97786 Oct. 27, 1932 Apr. 27, 1933 2,000.00 98100 Nov. 14, 1932 Feb. 14, 1933 4,000.00 98640 Dec. 2, 1932 April 3, 1933 5,000.00 98641 Nov. 25, 1932 May 25, 1933 5,000.00 Total 26,278.51 *1392 All of the foregoing notes were endorsed by the petitioner personally and in addition the petitioner had placed with the bank certain collateral to secure their payment. Note No. 98641, in addition to being endorsed personally by the petitioner, was also endorsed by Peter N. Jacobsen, G. Decker French, and Louis E. Roddewig, who apparently were also stockholders of the corporation or otherwise interested in it. After the close of business on December 24, 1932, the bank failed to reopen. The Superintendent of Banking of the State of Iowa took charge of the bank and on or about January 15, 1933, appointed Bert McCulloch as examiner in charge. Since that time McCulloch has continued to act as liquidator and receiver of the bank. After entering upon his duties at the bank McCulloch found the above described notes among the bank's assets. Within the next few weeks and after having learned that Airways was insolvent and that the petitioner was solvent, McCulloch had a conference with petitioner respecting the petitioner's payment of the notes. The petitioner advised McCulloch that he could make a lease of the Airways property to the city of *115 Davenport for a four-year*1393 term at an annual rental that would retire the notes during that period. McCulloch objected to a four-year extension of the notes, pointing out, and the petitioner admitting, that Airways was insolvent and without any funds and that if such a lease were accepted by the bank it would be only a matter of a month or two until the lease would be in default because of the lack of funds on the part of Airways to perform the covenants of such a lease. After several conferences the petitioner submitted to McCulloch a draft of the proposed lease to the city. McCulloch agreed to extend the time for the payment of the notes for four years on condition that the lease be assigned to the bank and the petitioner personally guarantee that the lease would be kept in full force and effect despite any default of Airways. The petitioner agreed to give such a guarantee. On March 20, 1933, Airways entered into a contract with the city wherein it leased the airport to the city for a period of four years commencing August 1, 1933, and ending July 31, 1937, at a rental of $7,500 a year. Under the lease Airways agreed, among other things, to own and keep on the leased premises at all times at least*1394 three airplanes of a certain value, horsepower, size, and accommodations; to keep the hangar and buildings then installed on the leased premises as well as the electric lighting equipment installed on said premises in good condition; to furnish a superintendent or other competent attendants at such premises for 24-hour service per day; to furnish any person or persons so desiring it airport service, including aircraft parking and storage space and other airport conveniences, and to collect therefor charges to be established from time to time by the city for the use of said premises; to pay all charges and expenses of adequately lighting the airfield and also charges and expenses in connection with the keeping and maintaining of the premises and equipment in good condition and repair and free from weeds and debris; to insure at its own expense the buildings, improvements, tools, machinery, equipment, airplanes, and other personal property on said premises against fire in at least the amount of $25,000 and against tornado in at least the amount of $10,000; to perform all covenants and agreements incumbent on it under the terms of its leases (i.e., leases to Airways of the land on which*1395 its airport was situated) and to pay promptly to its lessors when due any and all rentals which might thereafter accrue. The lease also contained the following provision: That at the expiration of this agreement, or sooner termination thereof, the City shall have the right and is hereby given the option to purchase for the sum of One ($1.00) Dollar, the hangar, buildings and structures now erected or hereafter to be erected on said premises, by the Airport [Airways], all lighting equipment, airplanes, machinery, tools and other moveable fixtures and/or personal property built, installed or located on the above described premises and that said Airport will relinquish all its rights, title and interest in and to said *116 property, excepting, restaurant building, gasoline filling station, miniature golf course and gasoline filling pit. On the same day that Airways entered into the foregoing contract with the city it assigned the contract to the receiver for the bank. The city accepted such assignment. Thereafter the city, pursuant to the assignment, duly made rental payments to the bank as follows: April 26, 1934 $7,500.00 Nov. 7, 1935 7,500.00 May 21, 1936 7,500.00 May 1, 1937 6,962.50 29,462.50 *1396 The foregoing payments were applied by the bank to the payment of the notes owing to it by Airways, the notes being liquidated as follows: Total principal amount of notes $26,278.51 Less offset allowance 217.80 Net 26,060.71 Interest on notes to date of payment 3,401.79 $29,462.50 The following statement shows the amounts paid by the city with respect to each of the notes during the indicated years: [1934] Note No. Principal amount Principal Interest 95377 $778.51 $778.51 $90.32 95552 500.00 500.00 57.69 96449 500.00 189.45 56.69 96704 1,200.00 1,200.00 125.45 96879 800.00 800.00 82.62 97057 5,000.00 507.36 97520 1,500.00 1,500.00 147.06 97786 2,000.00 191.75 98100 4,000.00 371.23 98640 5,000.00 447.77 98541 5,000.00 454.10 4,967.96 2,532.04 Interest 2,532.04 Total principal and interest 7,500.00 Less: Offset allowance Adjustment on interest * *117 The rentals payable by the city having been assigned to the bank to be applied on the indebtedness*1397 owing by Airways to the bank, Airways was left without funds to meet its operating expenses, chief among which were insurance and ground rent. During the years 1933 and 1934 Airways had an operating deficit in the total amount of $13,836.38. The petitioner personally paid the amount of such deficit. During 1933 and 1934 the city reimbursed him for the amounts so paid. Thereafter a question was raised as to the legality of such payments by the city and early in 1935 an act was introduced in the Legislature of the State of Iowa to validate the payments thus made by the city. This act was passed by the legislature and approved by the governor on May 4, 1935. During April 1934 a new city administration was elected for the city of Davenport. The new city officials so elected were not sympathetic with any projects supported by the petitioner or the Times Co., a corporation, of which the petitioner was president and a stockholder, which published at Davenport a newspaper known as The Daily Times. In an attempt to get the city to make reimbursement for operating expenses of Airways for the year 1935 the petitioner contacted the mayor, the airport committee of the city council, and*1398 several other members of the council. While the parties whom the petitioner contacted promised that steps would be taken towards making such reimbursement, as had been done in prior years, the council as a whole was unable to agree to take such action and at the close of 1935 had made no provision for any payment of the operating expenses of Airways. During the spring or early summer of 1936 the council rejected a motion to have the city make such reimbursement. During 1935, 1936, and 1937 the petitioner arranged with the Times Co. to furnish the necessary funds to keep Airways in operation and under the arrangement the Times Co. paid the following amounts for the purposes indicated: Date paid Amount Total for year Explanation April 2, 1935 $85.94 Supplies June 20, 1935 550.00 Borgeldt lease June 20, 1935 1,155.45 Insurance Nov. 20, 1935 3,290.55 Ground rent and insurance $5,081.94 Feb. 22, 1936 $200.00 Salary June 6, 1936 1,444.86 Ground rent and insurance July 1, 1936 2,345.58 Attorney's fees Oct. 19, 1936 73.50 Insurance Dec. 11, 1936 2,408.21 Ground rent, insurance, etc. 6,472.15 June 17, 1937 657.50 657.50 Ground rent Total 12,211.59 *1399 *118 The petitioner does not have any personal bank account and all expenditures made by him of every kind are carried through the books of the Times Co., which acts as the custodian of his funds. Apparently the petitioner keeps no books of account independent of those kept by the Times Co. In the books of the Times Co. there is kept an account with the petitioner designated "E. P. Adler - Personal Account" which is credited with items of income of the petitioner from various sources and is charged with expenditures made by him or on his behalf. In addition to the foregoing account the Times Co. keeps three or four other accounts with respect to the petitioner's affairs. Near the end of the year it is the practice of the times Co. to transfer out of these accounts the balances thereof and charge them to the petitioner's "Personal Account." Among such accounts during 1935, 1936, and 1937 was an account designated "E. P. Adler - Dav. Airways, Inc.", to which was charged the amounts set out above as paid by the Times Co. during 1935 through 1937 in connection with the operation of Airways. At the end of 1935 the petitioner instructed the bookkeeper of the Times Co. not to*1400 charge to his "Personal Account" the $5,081.91 expended by the Times Co. during that year in connection with the operations of Airways which was then charged to the petitioner's "Dav. Airways Inc." account, stating as his reason therefor that the expected the city would make reimbursement of such amount. The city council having declined in 1936 to make reimbursement of any expenditures made in connection with the operation of Airways and the petitioner having concluded that collection thereof could not be had, the $5,081.94 expended by the Times Co. during 1935 and the $6,472.15 expended by it in 1936, or a total of $11,554.09, was, near the end of 1936, transferred out of petitioner's "Dav. Airways Inc." account and charged to his "Personal Account." After the charge had been made to the petitioner's "Personal Account" there remained a balance to his credit of $1,738.26. At the end of 1937 the $657.50 expended by the Times Co. during that year in connection with the operation of Airways was transferred out of the petitioner's "Dav. Airways Inc." account and charged to his "Personal Account." After the charge had been made to the petitioner's "Personal Account" there remained a balance*1401 to his credit of $27,054.61. The petitioner has never been reimbursed for the amounts expended during 1935, 1936, and 1937 in connection with the operation of Airways and charged to his "Personal Account" as set out above. The petitioner's income tax returns for 1935, 1936, and 1937 were filed on the cash receipts and disbursements basis. In his income tax returns for 1936 and 1937 the petitioner deducted as bad debts the amounts of $11,554.09 and $657.50, respectively, on account of payments made by the Times Co. in connection with the operations of Airways during 1935, 1936, and 1937, as *119 set out above. In determining the deficiencies involed herein the respondent disallowed the deductions on the ground that the petitioner was not legally liable for the payment of such amounts and for the reason that the amounts were not paid to the bank as guarantor of the notes of Airways. The petition in this proceeding was filed with the Board on April 13, 1939. On April 14, 1939, the petitioner filed with the Commissioner a claim for refund in the amount of $170.79 for 1936 and a claim for refund in the amount of $5,421.29 for 1937. OPINION. TURNER: The petitioner contends*1402 that he is entitled to the deductions of $11,554.09 and $657.50 in 1936 and 1937, respectively, either as bad debts or as losses. Respondent contends that the amounts are not allowable deductions either as bad debts or as losses. In the early part of 1933 the petitioner was liable as endorser on 11 notes of Airways, totaling $26,278.51, which were held by the bank. The bank also held certain collateral of the petitioner as security for the payment of the notes. Within a few weeks after he took charge of the bank's affairs and when several of the notes had become due and the remainder would be due within a few weeks, McCulloch, after ascertaining that Airways was insolvent and unable to make payment and that the petitioner was solvent and able to make payment, conferred with the petitioner respecting the petitioner's making payment of said notes. In order to avoid having to make present payment of his liability as endorser on the notes and in order to reduce if possible the amount he would eventually have to pay on them, the petitioner entered into an agreement with McCulloch wereby an extension of the time of payment was granted for four years, the city leasing Airways' airport*1403 for a four-year period at sufficient annual rental to liquidate the notes, with interest, during that period and the petitioner agreeing with McCulloch to guarantee that the lease would be kept in full force and effect throughout the four-year period and that Airways would not default in the performance of its covenants thereunder. McCulloch knew and the petitioner knew that, since the rentals payable to the city under the lease were to be paid to the bank and applied on the notes of Airways, Airways would be deprived of necessary operating funds. The petitioner in performance of his agreement with McCulloch thereafter furnished, through the Times Co., the custodian of his funds, all the necessary operating funds required by Airways to perform its covenants under the lease. The petitioner was able to obtain reimbursement from the city of such funds furnished Airways during 1933 and 1934, but was not reimbursed from any source for the funds furnished during 1935, 1936, and 1937. *120 This is not the usual type of case where the endorser claims the right to deduct as a bad debt the amount paid by him to the creditor of the principal debtor pursuant to liability as endorser*1404 and recovery can not be had from the principal debtor. Instead, it is a case of an endorser who, realizing that the principal debtor, unassisted, is and will continue to be unable to make payment of its indebtedness, but with some financial assistance in carrying on its operations will be able to pay its indebtedness in full, but will not be able to make repayment of such assistance, renders, under a guaranty agreement with the creditor, financial assistance to the principal debtor, with a view to avoiding having to make present payment of his liability as an endorser and reducing to a minimum the amount of loss he would sustain thereon, and claims the right to deduct the amount of the assistance thus rendered. In the former type of case it has been held that the endorser was entitled to the claimed deducting of the amount so paid. ; ; ; . In *1405 , the taxpayer, a stockholder of a bank, was liable thereto as a guarantor on certain notes held by the bank and considered to be uncollectible. The taxpayer, without in any wise being subrogated to the bank's right to collect on the notes but in order to be relieved of his liability as a guarantor, paid the bank $28,000 in 1921. The amount was held to be an allowable deduction as a loss from the taxpayer's income for 1921. In , the taxpayer was an endorser on notes and a guarantor of accounts of the corporation in which he was a stockholder. In 1922 he advanced the corporation $1,000 with which to pay the interest on its indebtedness, taking the corporation's note for the amount thus advanced. In so doing the taxpayer knew the corporation was insolvent and that the note was worthless; however he considered that he was making a partial payment of his losses. Since the taxpayer was an endorser on notes and a guarantor of accounts of the corporation, it was held that the $1,000 constituted a deduction allowable to the taxpayer in 1922 as a loss sustained in that year. The purpose of the*1406 payment of the amounts involved in the Dillon and Adamson cases was either to relieve the taxpayers of or reduce the amount of their liability on the indebtedness of others for whcih they were liable. While in the instant case the payments made by the petitioner were to parties other than the bank to whom he was directly liable, yet the purpose and effect of such payments were the same as in the Dillon and Adamson cases and in our opinion fall into the same category as deductible losses. This, however, does not mean that the petitioner is entitled to deduct for 1936 the $5,081.94 paid during 1935. *121 During 1933 and 1934 the city made reimbursement to the petitioner of the operating deficit of Airways which he had paid during those years. The legality of such action on the part of the city was questioned and in 1935 a special act was enacted by the state legislature, ratifying the payments but granting no authority to the city for making any such payments in the future. During 1934 new city officials were elected who were not sympathetic with any projects supported by the petitioner or the Times Co. and at the close of 1935 they had made no provision*1407 for any payment of the operating expenses of Airways, despite the fact that the petitioner apparently had been very active in his efforts to get those officials to do so. Since the city was not obligated and apparently was without authority to pay any part of the operating deficit of Airways, and since there was no basis for expecting a recovery of it from Airways, we are of the opinion that the amount paid by the petitioner through the Times Co. during 1935 represented a loss sustained by him during that year and was deductible as such for that year. The amounts paid during 1936 and 1937 represented losses sustained in those years respectively and were deductible as such in those years. On brief the petitioner contends that, since Airways was dissolved and its affairs wound up in 1937 and he received nothing with respect to his stock, he is entitled to a deduction for that year of a loss of $1,000 representing the cost of 10 shares of stock in Airways. The petitioner made no assignment of error in his petition respecting the loss on stock owned by him in Airways. Consideration will not be given to issues which are not raised by the pleadings. See *1408 , and cases there cited. In this connection, however, it is to be observed that the petitioner's failure to raise the issue in his petition has not resulted in any detriment to him, since his testimony as well as that of McCulloch indicates that as early as the first part of 1933 Airways was insolvent and its stock was worthless. Decision will be entered under Rule 50. Footnotes *. No payment made during 1937 was made subsequent to May 1 of that year. ↩